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Answer: The frequent trading as a result of stack and roll strategy will lead to higher costs, which
## Explanation The correct answer is **A**. **About the MGRM Case:** Metallgesellschaft Refining and Marketing (MGRM) entered into long-term fixed-price contracts to supply oil products. To hedge these positions, they used a "stack and roll" strategy: - They bought short-term futures contracts - As these contracts approached expiration, they would "roll" them into new contracts - This created a mismatch between long-term obligations and short-term hedges **The "What if?" Scenario:** If MGRM hadn't faced the problems they actually encountered (falling spot prices and shift from backwardation to contango), their biggest remaining worry would be: **Transaction costs from frequent trading** - The stack and roll strategy requires constant trading to maintain the hedge position. Each time contracts are rolled over, there are: - Bid-ask spreads - Commissions - Market impact costs - Administrative costs These costs can accumulate significantly over time and erode the profitability of the hedging strategy, even if the market conditions remain favorable. **Key Risk Factors:** - **Basis risk**: The difference between spot prices and futures prices - **Rolling risk**: The cost/risk associated with rolling futures positions - **Liquidity risk**: Need to execute large volumes of trades frequently - **Funding risk**: Margin requirements for futures positions Even in ideal market conditions, the operational complexity and transaction costs of maintaining a dynamic hedging strategy would remain a significant concern for MGRM.
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In financial risk management, it is common to ask the "What if?" questions. To illustrate the point here, we will use the MGRM case as an example. The MGRM entered into long-term, fixed-price contracts to deliver oil products to end-user customers in 1993. In order to hedge, it implemented a dynamic hedging strategy called rolling hedge. However, since the spot oil prices fell significantly in 1993 and the oil price curve changed from backwardation to contango, the MGRM suffered a significant loss. We then consider a "What if?" question: what if the MGRM did not face any problem mentioned above (e.g., the spot prices did not fall significantly, and the price curve did not shift to contango)? What will be the MGRM's biggest worry?
A
The frequent trading as a result of stack and roll strategy will lead to higher costs, which
B
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