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Answer: Hedging liabilities by rolling forward futures contracts may create cash flow mismatches.
The correct answer is C. The case of Metallgesellschaft in 1993 is a prime example of how hedging liabilities by rolling forward futures contracts can create cash flow mismatches. Metallgesellschaft, a German conglomerate, entered into long-term oil futures contracts to hedge against the risk of rising oil prices. However, the strategy backfired when oil prices fell, and the company faced margin calls on its futures contracts. This led to significant losses and cash flow problems, as the company was forced to liquidate its positions at a loss. The lesson here is that while hedging can be an effective risk management tool, it is crucial to ensure that the hedging strategy is aligned with the firm's cash flow needs and risk tolerance. Rolling forward futures contracts can create a cash flow mismatch, as the timing of cash flows from the futures contracts may not match the timing of the underlying liabilities. This can lead to liquidity risk and potential financial distress if the firm is unable to meet its obligations when they come due.
Author: LeetQuiz Editorial Team
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A banking institution's risk manager seeks to understand recent occurrences of liquidity risk failures more thoroughly. To achieve this, an analysis of real-life scenarios is undertaken. Among the various cases reviewed, which key lesson could be most effectively illustrated through the example of Metallgesellschaft in 1993?
A
Negative public perception of emergency borrowing from the central bank can cause a bank run.
B
Positive feedback trading in illiquid instruments can cause excessive losses.
C
Hedging liabilities by rolling forward futures contracts may create cash flow mismatches.
D
Futures provide a better effective hedge for hedging commodities exposure than forwards.
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