Metallgesellschaft L1 [practice, foundation]
by David Harper, CFA, FRM, CIPM
33. In late 1993, Metallgesellschaft reported losses of approximately USD 1.5 billion in connection with the implementation of a hedging strategy in the oil futures market. In 1992, the company had begun a new strategy to sell petroleum to independent retailers, on a monthly basis, at fixed prices above the prevailing market price for periods of up to 5 and even 10 years. At the same time, Metallgesellschaft implemented a hedging strategy using a large number of short-term derivative contracts such as swaps and futures on crude oil, heating oil, and gasoline on several exchanges and markets. Its approach was to buy on the derivatives market exposure to one barrel of oil for each barrel it had committed to deliver. Because of its choice of a hedge ratio, the company suffered significant losses with its hedging strategy when oil market conditions abruptly changed to [source: FRM 2010 practice exam]:
- a. Contango, which occurs when the futures price is above the spot price.
- b. Contango, which occurs when the futures price is below the spot price.
- c. Normal backwardation, which occurs when the futures price is above the spot price.
- d. Normal backwardation, which occurs when the futures price is below the spot price.
[my adds]
33.2 Specifically, what is their hedging strategy called and what was the hedge ratio?
33.3 The question is mistaken to implicate the hedge ratio. As it turned out, MG was over-hedged such that economically they would have shown a net profit. What was the actual problem and what specific RISKS manifested?
33.4 What happens to the roll return in contango?
33.5 (advanced) Assume a positive correlation between oil and the market. What is the implied relationship between the short forward price and the expected future spot price of oil during (i) the original backwardation scenario that characterized MG’s history and (ii) the switch to contango?
Comments
Option ‘A’ is the correct answer.
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