Derivatives Mishaps Example for Free

Metallgesellschaft Corporation is one of the subsidiaries of Metallgesellschaft A.G. , a German Conglomerate which largely owned by institutional investors and banks such as Deutsche Bank AG, the Dresdner Bank AG, Daimler-Benz, Allianz and the Kuwait Investment Authority. In 1993, Metallgesellschaft Refining and Marketing known as MGRM which is one of the Metallgesellschaft's trading subsidiary, had decided to establish a huge amount of derivatives positions which consists of futures and swaps to perform hedging on its price exposure and MGRM was to sell certain amount of petroleum for up to 10 years at a fixed prices. Mostly the clients or customers of MGRM are retail gasoline suppliers, large manufacturing firms and government agencies. The total amount of petroleum barrels that MGRM had committed to deliver are 160 million barrels. MGRM provided their customer petroleum at a fixed price who they often face liquidity and margin issues when oil price rises and MGRM believed that it is possible to arbitrage with the spot market and long term contract. MGRM had provided their customers a chance to shift the price risk in the fluctuating oil price market as MGRM had confidence in their financial resources were able to manage risk transference efficiently. One of the MGRM hedging strategy in order to manage spot price risk was to use front-end month futures on NYMEX. Besides that MGRM employed "stacked" hedging strategy but not spreading them over longer dated and maturity. Eventually, things went opposite to MGRM's assumption and Metallgesellschaft had reported a total loss of $1.3 billion in late 1993 . Metallgesellschaft had requested bailout from the investors and banks with a total amount of $1.9 billion in order to rescue and prevent it from going into bankruptcy.

Causes of Derivatives Mishaps

One of the causes that lead to derivative mishaps is the assumption of economics of scale and was mistaken by MGRM by going for long future and entered into OTC swap agreements. When the prices of the oil rises, MGRM will generates a gain but when the price falls, MGRM will suffer losses. Therefore, this rolling strategy is working when MRGM hedging against MGRM client's trades when only the oil price drops while MGRM suffer loses when the price rises . MRGM's forward contract has leaded them into a dangerous position when there is a rising price of the oil. Such hedging strategy had been exposing the firm to three risk which is the basis risk, liquidity risk and also credit risk. The firm was hedging with a maturity structure which was mismatch with its delivery contracts. It will expose the firm to basis risk because the value of the short dated futures positions is not compensated by equal and opposite variations in the value of the long-dated delivery contract. The value of the contract will not be able to hedge perfectly because of the mismatch of the maturity. All the gain and losses are settled daily. The holder need to pay or receives an amount equal to the daily change in the future price. When the price drop, MRGM need to incur negative cash flow to fund for the margin calls. Besides that, the future contract contained an option which enabled the counterparties to closure the contract early if the New York Mercantile Exchange future contract was greater than the selling price of the MRGM. This option is attractive to the customer which have financial distress problem. Other than that, the hedge was created with a view that the market would be in backwardationA situation. The risk manager believes that the market will remain in the backwardation because it is usually happen in the stock market. Therefore, they decided to follow the hedge strategy. However, the market has shifted to contangoA where the futures prices are higher than the spot prices. This causes the increasing in the cost of the hedge. All the gain due to the short positions was more than offset by a loss due to the futures positions. It will causes certain issue as to the size of the firm's total open interest was a larger percentage of the total and making these position to be liquidated will be harder and more challenging. The firm also exposed themselves with the risk that not having enough amount of funds in case of immediate margin calls. The firm faced some problems in providing certain amount of funds to maintain the position.A hedge is supposed to transfer away the market risk but the firm was exposed to the risk that needs to find out the cash for the immediate margin call that caused by the contango effect. They were exposing themselves to 85 days worth of the entire output of Kuwait. If oil prices happens to decrease, MGRM would incur losses on their dedicated hedging positions and would undoubtedly receiving margin calls. As such leading to negative cash flow in the short run as no cash would be received for the gain in the value of the forward contracts until the oil was sold although the gain in the forward contract positions would offset the losses. No economic loss would occur because of their hedge strategy, but the size of their position created a funding risk. The stack and roll strategy cause the losses because in a contango market the spot price decreased more than the futures prices. Other than that, German accounting standards also compounded MGRM problems. Lower of Cost or Market (LCM) accounting is a standard required in Germany. While in the United States, MGRM undoubtedly met the requirements of a hedge and received hedge accounting. Therefore, profit was shown in MGRM financial statement. Their hedge losses were deferred because they offset the gains of their forward contract. However, MG was required to subscribe their current losses without recognizing the gains on their fixed-rate forward positions until they were realized by using LCM. MG's income statement was a failure since the German accounting standards did not allow for the netting of position.. This drastically changed the market arena for MGRM. Therefore, the swap counterparties required additional capital to maintain their swap positions and the NYMEX imposed more margin requirements on MGRM more than doubling their performance bond requirement. MGRM's positions may not have alarmed the marketplace and they might have been able to reduce their positions in the OTC market without getting their eyeballs pulled out if the hedge accounting had been acceptable in Germany.

Hedging Alternative to Avoid Mishaps

In this hedging activity did by Metallgesellschaft (MGRM), by guarantying their customers fix price for gasoline, heating oil and diesel fuel. This hedging had make MGRM expose to many different risk, price risk, credit risk and delivery risk.

MGRM could use many different ways to hedge their position. These hedging strategies have pros and con as shown below.

Alternative A

MGRM can use lower hedge ratio, reducing the hedge ratio will minimize cash flow variance and increase the company's liquidity risk. It also takes into account on basis risk, use correlation of assets as hedge ratio. However, by using this strategy MGRM's dynamic adjustments could be expensive; this is because the transaction cost will eventually increase.

Alternative B

MGRM could hedge with short maturity forwards; this action will let the company to reduce basis risk because MGRM has long short term futures. This action also increases the company's liquidity in market.

Alternative C

The other option for MGRM to hedge is to include option as part of their hedging strategy. Company could always use option to limit their lost to make sure the risk they face is manageable. MRGM could long zero cost collar as part of their strategy. Zero cost collar is a type of positive-carry collar that secures a return through the purchase of a cap and sale of a floor.A Also called "zero cost options" or "equity risk reversals." This could limit their downside lost. Besides, MGRM also can use long call option with similar maturity to protect themselves from exposing to too much risk. With call option, the company face limited downside and have give the company to realize unlimited profit. As show in the graph, x-axis shows the profit of the company and y-axis shows the price for the underlying asset (gasoline, heating oil and diesel fuel).

Alternative D

Furthermore, MGRM can transfer all the risk to a third party by selling off all the delivery contracts. By selling the delivery contracts, the company will obtain an origination fee that makes sure a certain profit. The cons from the action is the company has to give up most of the expected profits because not matter how much the contracts earn; the profit will be transfer to the third party. Besides, due to the complexity of the contract it will be hard to sell it. These contracts have non-transparency problem including counterparty risk, embedded option, long term maturity contracts, etc.

Alternative E

Another alternative is the company own physical storage of the underlying asset. The company can create a large network of storage facilities, having lots of inventory will help company to meet customers' demand. But, this alternative is not practical, because it is nearly impossible to store oil for 10 years and it will be very expensive to pay the storage cost. These are the suggested alternative that MGRM could use. But the final decision will still based on the financial experts. They will analysis the current economic performance, inflation and etc to make their final decision.

Lessons Learnt from Hedging:

Metallgesellschaft's near-collapse and experience with derivatives suggests some lessons. Value hedging and cash flow hedging is very important because a hedge with mismatched maturity can create to an enormous funding risks. Problems may occur when a hedging strategy is set up without a careful regard for the financing it may require. MG's strategy should make both of the cash flow patterns and its firm's value a crucial part to consider or put it as the main concern. Besides that, another lesson learned is that the accounting and disclosure conventions must be appropriate. Conflicting and inappropriate accounting and disclosure conventions can create uncertainty about a firm's hedging strategy and make it difficult for the firm to raise income when it needs to. The case of MG shows the dangers of treating derivatives positions differently from the assets or liabilities that the derivatives are being used to hedge. There should not be accounting reorganization of gains and losses on derivatives positions used for hedging unless the gains and losses on the positions that are being hedged also are recognized. In additional, it is also very important that both senior managers and the board of directors of a firm should understand how a firm is using derivatives. They should understand the risks associated with it if they use derivatives as part of the hedging strategy. In other words, approval from the board is needed before the strategy is implemented. Senior managers should understand the firm's exposure to changes in prices and to basis changes, and should be informed about potential funding needs. For the case of Metallgesellschaft, it is believe that its supervisory board did not fully understand the risks associated with MGRM's forward-contracting and associated hedging strategy or did not correctly evaluate these risks when approved the strategy. Metallgesellschaft also gave us a lesson about the important of boards and managers to acknowledge financial and regulatory constraints. It is important for hedgers to foresee or expect and to manage funding needs. Financial institutions or the creditor banks play an important rule here. It needs to have the backing of financial institutions that understand and approve of the firm's use of derivatives, and are willing to advance credit to fund margin outflows on derivatives positions. For the case of Metallgesellschaft, it is believe that they did not have such an understanding with its creditor banks. Another lesson we can learn from Metallgesellschaft is that cash is the crucial thing when in the time of distress or debacle. Metallgesellschaft's delivery contracts were not liquid enough and facing difficulty to the extent of very low possibility to sell it off at a reasonable price. As the strategy was not able to finance by it ownself, Metallgesellschaft had to request bailout from investors and banks to settle its market debts and avoid bankruptcy. Other than that, complexity is another matter influence the risk management which will makes the risk management more difficult. Somehow, the implementation and analysis of Metallgesellschaft's strategy was rather complex than the original strategy planned beforehand. The complexity of cash-out option ,delivery contracts and their enormous derivative positions had cause difficulty in evaluating its economic of oil trading. Complexity indirectly building obscurity and confusion resulting in vulnerability in business and difficulty in financing. Last but not least, the other lesson that can be learned is that a firm which established a huge position in market will never gets undetected. When a firm controlling such a large share of open interest, markets can become dysfunctional in two ways which is either the company can gain competitive advantage and to eliminate its competitors , if those participants remain stagnant and disorganized; or the company itself can be eliminated, if other market competitors begin to fulfill the role of counterparty and trade against the company in an organized manner. As Metallgesellschaft gigantic hedging position is transparent enough to alert the specialists in the oil markets, the specialists knew that Metallgesellschaft would have no choice but continue rollin. The specialist traders were waiting for the chance when Metallgesellschaft started to move a big position . Eventually, the lessons we can learned from the case of Metallgesellschaft include the importance of value hedging and cash flow hedging, the accounting and disclosure conventions must be appropriate, both senior managers and the board of directors of a firm should understand how a firm is using derivatives, the importance of boards and managers to acknowledge financial and regulatory constraints, cash is King when in the time of debacle, avoid complexity which affects risk management and a big position in the markets never goes undetected.

Conclusion

Although hedging is a good way to manage a firm's exposure to risk, risk manager should be always be aware and be careful when performing hedging. As what had lead to MGRM's derivatives mishaps is they had overhedged , all the necessary information and data must be collected and carefully calculated and the right amount of the underlying assets needed to be hedged should be measured well planned beforehand. Besides that, Board of Directors and managers must understand the derivatives strategies and implication. As from the case of MGRM , it suggest that the Board might not fully understand the risk associated with the hedging strategy and did not evaluate the risk when approving them. So it's critical that Boards and manager must understand the using of derivatives as hedging strategy and their potential risk and ramifications. In conclusion , hedging will be beneficial to firms as it can work as protection against price movements but it will works against you like what had happened to Metallgesellschaft if one does not carry out the hedge cautiously, so everything must be planned carefully and managers must be sensitive and knowledgeable about the risk of hedging and always aware of regulatory actions by the officials and potential consequences when establish a hedging position.

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