International Financial Management of Lufthansa - Essay Example

International Financial Management: Lufthansa Case Study In determining whether the action of Herr Ruhnau was so careless as to warrant his ousting from the firm, it is necessary to consider a number of factors that surround the situation. Although some critics see his action as careless, some may see it as a prudent and also within the requirements of the financial risk management. To begin with, it is necessary to determine if there were any policies that prohibited a manager from carrying out the gamble (Anderson 47). Most firms have their risk policies that classify risks in order to predetermine the action of the managers and executives when faced with a certain financial risk. This is supposed to help their managers to know exactly what to do as and when they are in a situation where they have to make a critical decision about a big risk such as the one that Herr Ruhnau took. If such policies existed at Lufthansa, it would be easy to know whether the actions of Herr Ruhnau were careless and if he ignored standards in and to follow his gut feeling to make such a big decision (what kind of policies, list some of it). For instance, like having a limit on how must risk in terms of the amount of money involved a manager can take without involving the board of management. I have also talked about this in the conclusion) Herr Ruhnau’s decision can be viewed in two main perspectives. First it can be viewed from the perspective of the fact that as a manager, he had to take the action he thought was beneficial for the firm. Punishing him for making such a decision would be considered to be unfair in that when he took the role of the CEO of the firm, he took the responsibility to be making such decisions. As Ayse (212) says, it is not good for executive managers to be limited with regard to how they make their decisions. As a result, in determining whether Ruhnau’s actions were careless or necessary in that situation, it is necessary to tread carefully on the line and make sure that all factors are considered. Ruhnau decision was to leave fifty percent of the risk that the firm was taking with regard to buying the Boeing planes in advance and offering o pay later when the airplanes were delivered. This left the firm exposed to a risk of over 2.5 million dollars not covered. He also refused to consider other alternatives to cover the risk, such as forward contracts in order to protect Lufthansa from the risk of shifting exchange rates. He had analyzed that the dollar could only rise for a short time and so it would be expected that it could only go down from there. In this regard, it is necessary to note that he had already taken caution to make sure that the risk was not too high to take. In fact, he covered 50% of the risk, just in case his analysis about the future of the dollar rate was wrong. These two factors when put together indicate that he had taken the necessary measures that where critical for him to protect the firm from unnecessary financial instability (Merna 141). In managing international financial risk, the issue of purchasing parity conditions must be taken into consideration (Daelen, 59). This refers to the congruence of prices of goods in two markets with regard to the currency exchange. For instance, according to this principle, if a certain amount of the currency is bought using a local currency, the amount gained should be able to buy an equivalent of goods it would in the foreign market. Ruhnau can be seen as having considered this because he knew that based on this, the dollar rate could not continue hiking for too long without violating the parity conditions principle. Ruhnau used currency forwards in order to manage the risk. Currency forwards is an agreement to deliver a certain amount of value at a predetermined time and a predetermined exchange rate. It protects the firm from any chances that the currency exchange rates will change to its disadvantage. However, if the exchange rates change in a way that the firm cannot benefit, it will mean that the firm will not benefit. Ruhnau used this as a way to secure half of the transaction. It was necessary for Ruhnau to use currency forwards because his prediction that the dollar rates would not continue to increase was only based on parity issues. However, inflation is also another issue he could have considered. Inflation is the process by which currency loses value as the price of goods increases. The rate inflation in one economy can differ significantly from the rate of inflation in another and this can lead to the exchange rates shifting in a way that was not expected. According to the above graph showing the expected progression for each cover method, it is clear that Ruhnau’s expectation was wrong. It is clear that a put option cover and a 100% forward cover were less expensive than the 50% cover that he chose. He thought that if he covered the entire risk, the firm may lose too much because according to him the risk was not significant and so there was no need to invest too much in covering a risk whose probability was low. According to risk management theory with regard to corporate finance, a manager should never take a risk that if it was to materialize it would lead to drastic outcomes such as the firm going bankrupt (Chew 48). Such a risk must be avoided even if the opportunity to make a gain from it is high (Hampton 209). Executive managers like Herr have to consider the risk and determine if the risk is so high that if it was to materialize, the firm will have to face such big difficulty that it is survival would be affected (Graham, 104). When it comes to managing finical risk in a firm, there are two main risks that the managers should consider. There are the downside risks which if they materialize the firm will have to be pushed out of the market. These downside risks can be managed in two main ways (Rezaee 48). First, the manager should assess the risk and then determine its level of probability. After that, he can decide to hedge it if he or she has a way that he can hedge it in a way that the hedging cost is much lower than the cost of the risk if it was to materialize when not covered. In such a case, the risk can be covered using the cheapest and most reliable cover. The second way is when the manager decides that a certain risk has no option to be covered with while keeping the cost down (Graham 78). For such a risk, even if the possible returns are attractive, the manager should be prudent enough to avoid the risk altogether. However, in doing so, he will have forgone the possible benefits such as making a profit, that would have been gained from taking the risk. The question to answer in this case of this is what the manager did. As a result, it is necessary to analyze the risk that Herr Ruhnau took and therefore determine if it was the kind of risk that the firm could not have afforded because it could have jeopardized the future of the firm if it was to materialize. Having covered half the risk, Herr Ruhnau left over 2.5 million dollars uncovered. Although his speculation was that the dollar had risen as much as it could and that the only way was for the dollar was to start going down, this was not guaranteed. While it was logical to speculate that the dollar would start falling after reaching the exchange rate of 4 dollars per DSM, there is nothing to have prevented the dollar from going even further and still continue to rise even to the pint when the payment for the planes was due (Daelen 45). This would have put the firm in a very critical financial position because considering that the amount was over 2.5 million dollars (in 1980s this must have been a lot of money and not even a very huge firm like Lufthansa would have afforded losing three or four times this amount), this would have been devastating to Lufthansa. Even Herr Ruhnau’s analysis that the dollar would not go beyond 4 dollars before starting to fall, the chance and probability that the dollar could still rise even reaching up to 8, 10 or even more dollars was still there. If this could have happened, it would have been very hard for Lufthansa to sustain such a loss and still be able to continue with its operations. In this regard, even though Herr Ruhnau as an executive had the right to make such a big decision for the firm, it was still a big gamble and he should have considered that if this was to happen and that if his analysis of what would have happened to the dollar rate was wrong, Lufthansa would have incurred a loss that was unbearable and that would have probably faced a bankruptcy. However, in putting forward this kind of argument, it is necessary to note that the context of the case must be taken (Hull 78). For instance, although there are cases where today one currency such as USD can be seen to rise against another such as Deutsche Mark constantly even past the levels where the industry experts had hoped would be optimum, these situations were not common in 1980s when Herr Ruhnau was making the decision. If it was today where it has become even harder to predict the fluctuations of the currency rates because the volatility of the exchange rates has increased, maybe Herr Ruhnau would have known better than to take such a big gamble. Considering these factors, Herr Ruhnau should not be fired and he should be given a second chance because his risk management strategy was relatively effective. Even in giving him a second however, the board can come up with some risk-taking rules for the firm so as to avoid such a misunderstanding in the future. What can be seen is that the situation exposed not only Herr Ruhnau’s actions but also the fact that the business did not have proper standards for risk-taking. In this regard, it may be necessary to retain Herr Ruhnau but come up with risk-taking processes that guide a manager on how to take risks. For instance, the firm can come up with a policy that determining that executives cannot take risks that exceed a certain amount in dollar value without consulting with the board members. This can help in making sure that Herr Ruhnau, or whoever else who can hold his position in the firm will not make such a big decision on his own. Such a big decision in any firm always requires a lot of consultations and to make sure that at least a number of people have been involved (Merna 230). One person’s mind may be wrong and it would be risky for him to make the decision alone. In this regard, while the decision by Herr Ruhnau can be seen as careless from one perceptive, it is also necessary to note that the firm, and by extension the board of directors had as much responsibility for not taking the first step and making sure that the firm is protected by having standards that make sure that no one manager can take such a risk alone. Herr Ruhnau could argue that whatever he did was within his mandate and that as a manager he had the right as well as the responsibility to make such critical decisions. He can cite the fact that his decision, while not giving the firm the maximum possible gains from the transaction, proved to be effective in making sure that the cost of managing risk was kept low while at the same time offering a relatively good cover against the risk. As discussed in this response, it has been identified that firm may need to have policies on financial risk management that should guide while executives such as Herr Ruhnau can approach risky situation. Lufthansa did not have such policies and therefore Herr Ruhnau ha a leeway to make the decision which in his wisdom thought to be the most effective. Herr Ruhnau can therefore argue that he did not do anything that was wrong or against any policy in the firm and that terminating his employment would be termed as a wrongful termination of employment which is illegal. Works Cited Anderson, Darren. Corporate survival: the critical importance of sustainability risk management. New York, NY: iUniverse, 2005. Ayse, Cyrus. Risk Management and Corporate Sustainability in Aviation. New York, NY: Ashgate Publishing, Ltd., 2012. Chew, Donald. Corporate Risk Management. New York, NY: Columbia University Press, 2013New York, NY. Daelen, Michale. Risk Management and Corporate Governance: Interconnections in Law, Accounting and Tax. New York, NY: Edward Elgar Publishing, 2010. Isaac, Parson. Risk Management and Corporate Governance: Interconnections in Law, Accounting and Tax. New York, NY: Edward Elgar Publishing, 2010. Graham, Allan. Introduction to Currency Risk. London, UK: Routledge, 2013. Graham, Gareth. Corporate Credit Analysis: Credit Risk Management. New York, NY: Global Professional Publishi, 2000. Hampton, Justus. Fundamentals of Enterprise Risk Management: How Top Companies Assess Risk, Manage Exposure, and Seize Opportunity. New York, NY: AMACOM Div American Mgmt Assn, 2009. Hull, Ellen. Risk Management and Financial Institutions. Hoboken, NY: Wiley, 2015. Merna, Taurus. Corporate Risk Management. New York, NY: John Wiley & Sons, 2011. West, McDonalds. Project Finance in Construction: A Structured Guide to Assessment. Hoboken, NY: John Wiley & Sons, 2010. Rezaee, Zabihollah. Corporate Governance Post-Sarbanes-Oxley: Regulations, Requirements, and Integrated Processes. New York, NY: John Wiley & Sons, 2007. Spedding, Linda. The Due Diligence Handbook: Corporate Governance, Risk Management and Business Planning. New York, NY: Elsevier, 2009. Read More