Nov 10

Metallgesellschaft case – 6 min briefcast

by David Harper, CFA, FRM, CIPM

A quick summary of the Metallgesellshaft (MG) case. Tips for FRM candidates:

The underlying instruments were short positions in long-term forward contracts to deliver oil
The hedge was a stack-and-roll hedge: long positions in short-term futures contracts that were rolled over consecutively
The strategy depended on the continuation of (i) stable or gently increasing spot oil prices and (ii) backwardation [note: the text incorrectly uses the term normal backwardation]
The market shifted to contango
Problem #1 (basis risk): losses on futures exceeded offsetting gains on forwards. All hedges attach with some basis risk; here the basis risk is acute due to long-term/short-term mismatch
Problem #2 (liquidity risk): futures are settled daily but forwards incur counterparty (credit) risk as they await settlement. Here the futures loses required immediate cash which could not be funded by the gains on the forward as they were unrealized
Problem #3 (operational risk): the futures were marked-to-market but the forwards were not. So, losses were recognized immediately but offsetting gains could not be recorded. This itself was a paper accounting issue, but it eroded MG’s counterparties faith.

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