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Answer: Contango, which occurs when the futures price is above the spot price.
## Explanation **Correct Answer: A - Contango, which occurs when the futures price is above the spot price** **Background:** Metallgesellschaft had: - Long-term fixed-price oil delivery contracts (short physical position) - Hedged with short-term futures contracts (long futures position) - Used a 1:1 hedge ratio **The Problem:** When the market moved into **contango** (futures price > spot price), Metallgesellschaft suffered from: 1. **Negative roll yield**: When rolling over short-term futures contracts, they had to sell expiring contracts at lower prices and buy new contracts at higher prices 2. **Cash flow mismatch**: - Received fixed prices from long-term contracts - Paid margin calls on futures positions as prices moved against them - Had to constantly roll positions at a loss in contango markets **Key Definitions:** - **Contango**: Futures price > Spot price (market expects prices to rise) - **Normal Backwardation**: Futures price < Spot price (market expects prices to fall) **Why contango hurt them:** - Their hedging strategy assumed stable or backwardated markets - In contango, the cost of rolling futures positions created continuous losses - Despite having profitable long-term contracts, they couldn't withstand the short-term cash flow pressures This case is a classic example of **basis risk** and **liquidity risk** in hedging strategies.
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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:
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.
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