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Metallgesellschaft’s Hedging Debacle

Q1) Why did the MG’s Supervisory Board end its forward delivery program and liquidate its derivative
positions in response to large unrealized losses in derivatives position when, in fact, its forward delivery
contracts were in the money?

Ans) Although the forward delivery contracts were in the money, the money was unrealized and hence
there were no enough cash inflows. Cash inflows would have been at the time of selling the oil. But on
the other side, due to the decrease in prices and hence leading to margin calls, the board did not see the
funding risk it possessed and hence could not be in the futures derivative market longer. For this reason,
they had to liquidate its derivative position.

Q2) Did the board panic in the face of the huge margin calls?

Ans) Yes, the board panicked as they had not accounted for the required margin calls and funding risks.
The board was of backwardation view as that is what was happening since a decade in the oil market.
And hence they were not expecting the change to contango.

Q3) Could it be that the board did not understand the full implications of the hedge strategy and
panicked in the face of huge margin calls?

Ans) Yes, it seems that the board did not account for the funds required in case of oil prices falling and
hence did not understand the implications of the hedge strategy. More than a hedging strategy this
seemed as a speculation of oil prices going up. Also, the board did not account for the roll over risks as
they thought of oil prices in futures market to be in backwardation. The stack and roll option, although
sounded economically profitable but since they could not be in this strategy for long (in account of
margin calls required) had to quit the positions leading to extensive loss. Moreover, the duration of the
forward contract and the futures derivative investments were not matching which posed a problem to
them.

Q4) Did MG have funding problems?

Ans) Yes. Had they wouldn’t have funding problems, they could have stayed in this strategy for long and
balanced out the losses in derivative markets with the profits of forward markets which would have
been realized once the selling of oil had taken place at the fixed delivery price.

Q5) Some critics say that MGRM’s stack and roll strategy was flawed because it exposed it to rollover
risk, funding risk, and credit risk. Is this the reason for liquidating the derivatives position?

Ans) Yes, it did expose them to rollover risk, funding risk as well as credit risk; but they had mitigated
the credit risk by giving a sell out option. Rollover risk was not very huge as compared to funding risk.
Hence funding risk was the key reason for them to liquidate the derivatives position.

Q6) Why did management choose a hedge with a mismatched maturity structure? Why did
management run such a large risk?

Ans) The management chose a hedge with a mismatched maturity structure because the maturity
structure in case of derivative market is maximum of that of 3 months and that of their forward contract
was of 10 years. The same could not have been done in the futures derivative market. Also, they
entered futures market with hedge ratio 1 i.e. for every barrel in forward market they invested in
futures market and hence the size of investment was huge (160 million barrels). For this reason, they
stacked all their investment in the 1st expiry contract as it has highest liquidity compared to other expiry
contracts. They run such a large risk as they wanted to be profitable incase the oil prices goes up.