Financial Risk Manager Part 1

Explanation

Funding liquidity risk refers to the risk that a company will not be able to meet its current and future cash flow and collateral needs, both expected and unexpected, without affecting its daily operations or financial condition.

In the Metallgesellschaft case:

• The company offered customers the opportunity to buy oil and gasoline at a premium above the average price of futures contracts expiring over the next 12 months
• When oil prices dropped sharply from about $21 to$14 per barrel, the company suffered losses of approximately $900 million
• These losses were realized immediately as the futures contracts were marked to market
• The gains from customers, which could have offset the losses, could not be realized until several years later
• This created a shortage of short-term cash outflows, leading to funding liquidity risk

Why other options are incorrect:

A. Credit risk - This refers to potential that a borrower or counterparty will fail to meet its obligations. In this case, losses were not due to customer defaults but rather price fluctuations.

B. Interest rate risk - This pertains to losses due to changes in interest rates. The losses were caused by oil price fluctuations, not interest rate changes.

D. Operational risk - This involves losses from inadequate internal processes, people, or systems. The company's strategy was not flawed due to operational failures but rather unexpected oil price drops.

The Metallgesellschaft case is a classic example of funding liquidity risk where the company was unable to meet its short-term cash flow needs due to sudden price movements.