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Answer: Contango, which occurs when the futures price is above the spot price.
## Explanation This question refers to the famous Metallgesellschaft case study in risk management. Here's the detailed analysis: ### Background - Metallgesellschaft sold long-term fixed-price petroleum contracts (5-10 years) - They hedged these long-term obligations with short-term futures contracts - Used a 1:1 hedge ratio (one futures contract per barrel sold) ### The Problem When the market shifted to **contango** (futures price > spot price), the company suffered significant losses because: 1. **Contango Definition**: Futures price is above spot price 2. **Rolling Costs**: As short-term futures contracts expired, they had to be "rolled over" to new contracts 3. **Negative Roll Yield**: In contango, rolling contracts forward involves selling at a lower price and buying at a higher price, creating a cost 4. **Cash Flow Mismatch**: While the long-term contracts generated profits over time, the short-term hedging created immediate cash flow losses ### Why Option A is Correct - Contango occurs when futures price > spot price - This created negative roll yield and cash flow problems - The company was effectively "short" the roll (selling low, buying high) - This is a classic case of basis risk and hedging mismatch ### Why Other Options are Incorrect - **B**: Incorrect definition of contango - **C**: Incorrect definition of normal backwardation - **D**: Normal backwardation (futures < spot) would have benefited their strategy The Metallgesellschaft case demonstrates the importance of understanding term structure, basis risk, and cash flow implications 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.