DERIVATIVE DEBACLES

In 1993 a report was published widely by a group of 30, which was about the risk associated with the derivatives. The group consisting the members of International Financial Community. The group initiated four kind of risks associated with derivatives, which are:

Market Risk : The risk to earnings from adverse movements in market prices. Operational Risk : The risk of losses occurring as a result of inadequate systems and control, human error, or management failure.

Counterparty Credit Risk :The risk that a party to a derivative contract will fail to perform on its obligation.

Legal Risk : The risk of loss because a contract is found not to be legally enforceable. Derivatives are legal contracts.

Like any other contract, they require a legal infrastructure.

These four kind of risks are not unique to derivative instruments They are the same types of risks involved in more traditional types of financial intermediation, such as banking and securities underwriting.

The rapid growth of derivative trading in recent years poses some special problems for the financial markets. It also reflects advances in the technology of risk management. The conventional wisdom views derivative markets as markets for risk transfer. The derivative markets do not create new risks, they just facilitate risk management.

Introduction

 a.

Metallgesellschaft A.G.

14th largest corporation in Germany. b. Conglomerate with interest in metal, mining and engineering businesses and 15 subsidiaries. MG Refining & Marketing ( MG )
a. b. c.

US oil trading subsidiary. New entrant to US market, low market share. Goal to develop a fully integrated oil business in US.

Dr.Heinz C. Schimmelbusch ( CEO of MG ) He started his career in 1973 with Metallgesellschaft AG, Germany where he rose to the position of the Chairman of the Management Board.

In 1989 the company obtained 49% of stake in Castle Energy, U.S oil exploration company. Purchased output of refined products at guaranteed margins on a long term contacts.
In 1992,1993 singed a large number of long term contracts with independent retailers. Delivery of gasoline , heating and jet fuel oil.

MGRM contacts to buy all the refined outputs from the castle energy for 10 years. Estimated volume 126,000 barrels/day ( 460M barrels over the next 10 years ). Guarantees a fixed margin to castle energy.

MG developed 3 types of contract programs.

Firm Fixed : Under firm fixed a customer agreed to fixed monthly deliveries at fixed prices.

Firm Flexible : Similar to the previous but giving customers extensive rights, to set the delivery schedule. MG was obligated to a total of 52M barrels.
Guaranteed Margin : Under which MG agreed to make deliveries at a price that would assure a customer a fixed margin, relative to the price offered by its geographical competitors. $3-$5 built in margin per barrel.

MG was a New entrant to the U.S oil market.

MG didnt had a significant market share.

MG had No competitive advantage in its cost of supply.

MG spotted that what it thought was an innovative marketing strategy, to sell financial petroleum to the independent and quasiindependent retailers.

MG embedded a cash out option on its supply contracts.

If energy prices rise above the contract price, counterparty can sell-back the remaining forward obligations for differences between the near-term futures price and contracted futures price. MG`s protection to customer from the default risk, which further creates liquidity risk for customer.

MG hedged the risk of rising oil prices with both short dated energy future contacts and OTC swaps.
MG`s total derivative position was 160M ( barrel for barrel )

The hedging strategy MG used was known as Rolling Forward .

Key aspects of this strategy were: 1) Concentrated on the short dated futures and swaps.

2) Position had to be rolled forward monthly, with downward adjustment for the delivered oil to keep 1:1 ratio.

If futures prices are below spot prices, Backwardian. If futures prices are above spot prices,Contango.

In a typical commodity market, the futures will be above spot, i.e., the market will be in contango.
In some commodity markets (especially oil) futures prices have remained below spot for long periods of time.

MGRMs stack-and-roll hedging strategy exposed it to basis risk. Because the price behavior of its stack of short-dated oil contracts might diverge from that of its longterm forward commitments. the behavior of energy futures prices became most unusual in 1993. Prices followed Contango Instead of Backwardian.

MGRM was forced to pay a premium to roll over each stack of short-term contracts as they expired.
These rollover costs reflected the cost of carry normally associated with physical storage. Management Feared that these rollover costs could add further to MGRMs losses. chose to liquidate the subsidiarys hedge and terminate its long-term delivery contracts with its customers.

oil prices began rising in 1994, soon after MGRMs new management lifted the firms hedge. It thus appears that MGRM could have recouped most if not all of its losses by simply by sticking to its hedging program. Criticisms of MGRMs hedging program have focused on two issues:

1) Assumptions of the MGRMs Hedging strategy architects :

Key Question was whether the change was Temporary or persisted.

Soybeans & copper Example:

2) Steps MGRM could have taken to reduce the variability of its cash flows.
MGRM was over hedged because short-term oil futures prices tend to be much more volatile than prices on long-term forward contracts. Edwards and Canter find that the correlation between them is approximately 50 percent. Hedging strategy was speculative in its design and intent.

Although German accounting standards and the contango market both contributed to MG's problems but true problem with MGRM was the size of their position.

The Avg trading Volume is 15000 to 30000 contracts per day.

MGRM reportedly holding a 55,000 contract position in these contracts. Wherever the truth lies, MG's Supervisory Board shares the blame for this situation.

Deutsche Bank was not only a creditor to MG but also one of its largest shareholders. Deutsche Bank executive, Ronaldo Schmitz, was chairman of MGs board of supervisors at the time. Experts in derivatives, notably the late Merton H. Miller, a Nobelwinning economist, argued that Deutsche Bank was to blame because it panicked. Unrealized Gains would have resulted in 170 Million Loss Rather than 1.5 Billion .

The management of MG would have benefitted from implementing the recommendations put forth in the Group of Thirty Derivatives study. These recommendations are basic, but the blatant disregard for these principles cost MG a mere $1.5 billion. Every Few Weeks Companies lose money by either speculating or by having lack of hedge ratio understanding.

MG's disaster in the oil markets should be seen as a Reminder to the corporate community to understand the nature of their position in financial markets and to understand the ramifications of market movements on your financial positions.