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Answer: Hedging liabilities by rolling forward futures contracts may create cash flow mismatches.
**Correct Answer: C** **Explanation:** The Metallgesellschaft case in 1993 is a classic example of cash flow mismatch risk. The company used short-term futures contracts to hedge long-term forward commitments in oil. When oil prices fell, Metallgesellschaft faced substantial margin calls on their futures positions while their long-term forward contracts showed paper gains that couldn't be realized immediately. This created a severe liquidity crisis despite having a theoretically sound hedging strategy. **Why other options are incorrect:** - **A:** This describes the Northern Rock case in 2007, where public disclosure of emergency borrowing from the Bank of England triggered a bank run. - **B:** This refers to the Long-Term Capital Management (LTCM) case in 1998, where positive feedback trading in illiquid instruments amplified losses during the Russian debt crisis. - **D:** Both forwards and futures can effectively hedge commodities exposure, but the Metallgesellschaft case specifically demonstrates the liquidity risk created by cash flow mismatches when using futures contracts with margin requirements.
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A risk manager at a bank is seeking to better understand recent liquidity risk failures. Several real-life cases are reviewed. Which of the following lessons would be best illustrated by the case of Metallgesellschaft in 1993?
A
Negative public perception of emergency borrowing from the central bank can cause a bank run.
B
Positive feedback trading in illiquid instruments can cause excessive losses.
C
Hedging liabilities by rolling forward futures contracts may create cash flow mismatches.
D
Futures provide a better effective hedge for hedging commodities exposure than forwards.