Financial Risk Manager Part 1

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• A: Although MGRM did adopt a dynamic hedging strategy, it was not outdated or largely ineffective.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.