Funding liquidity risk refers to the risk that a company will not be able to meet its current and future cash flow and collateral needs, both expected and unexpected, without affecting its daily operations or financial condition. In the Metallgesellschaft case, the company offered its customers the opportunity to buy oil and gasoline at a premium above the average price of futures contracts expiring over the next 12 months. However, when the price of oil dropped sharply from about `21` to \`14 per barrel, the company suffered losses of approximately \$900` million. These losses were realized immediately as the futures contracts were marked to market. The gains from customers, which could have offset the losses, could not be realized until several years later. This situation led to a shortage of short-term cash outflows, thereby creating a funding liquidity risk. Therefore, the Metallgesellschaft case is a classic example of funding liquidity risk, where the company was unable to meet its short-term cash flow needs due to a sudden drop in oil prices.

Choice A is incorrect. Credit risk refers to the potential that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms. In the Metallgesellschaft case, the company's losses were not due to any default by its customers or counterparties, but rather due to a sharp drop in oil prices.

Choice B is incorrect. Interest rate risk pertains to the potential for investment losses due to a change in interest rates. In this scenario, Metallgesellschaft's losses were not related to changes in interest rates but were caused by significant price fluctuations of heating oil and gasoline.

Choice D is incorrect. Operational risk involves loss resulting from inadequate or failed internal processes, people and systems, or from external events. The company's strategy was not flawed because of operational failures; instead it suffered from an unexpected drop in oil prices which led them into funding liquidity issues.

Things to Remember

• Credit risk is the risk that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms.
• Interest rate risk pertains to the potential for investment losses due to a change in interest rates.