Financial Risk Manager Part 1
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Metallgesellschaft Refining and Marketing (MGRM), a U.S. subsidiary of the German oil company Metallgesellschaft, lost over $1.5 billion as a result of a poor dynamic hedging strategy. What triggered the loss? The company:
Other
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A
Adopted an outdated and largely ineffective hedging strategy called a "stack-and-roll hedge".
B
Bought too many long terms futures contracts.
C
Failed to predict the significant rise in oil prices in 1993.
D
Suffered a significant decline in oil prices resulting in huge unrealized losses and subsequent margin calls.
Explanation:
Explanation
MGRM suffered a significant decline in oil prices, which led to massive unrealized losses and subsequent margin calls. The company used short-term futures to hedge its position due to a lack of alternatives, as the long-term futures contracts available were highly illiquid.
Key Details:
- MGRM's open interest in unleaded gasoline contracts was 55 million barrels in the fall of 1993
- Average trading volume was only 15-30 million barrels per day
- The company encountered problems with timing of cash flows required to maintain the hedge
- While cash flows would have canceled out over the entire hedge life, MGRM lacked necessary funds to maintain its position
- The fundamental issue was inadequate funds to mark positions to market and meet margin requirements
- The significant decline in oil prices exacerbated the situation, leading to huge unrealized losses and margin calls
Why Other Options Are Incorrect:
- A: Although MGRM did adopt a dynamic hedging strategy, it was not outdated or largely ineffective. The problem was not with the strategy itself but with liquidity and funding issues.
- B: MGRM actually used short-term futures due to illiquidity in long-term contracts, not too many long-term contracts.
- C: The problem was a decline in oil prices, not a failure to predict rising prices.
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