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MG's Derivatives

MG's Derivatives

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Published by Waheed Khan

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Published by: Waheed Khan on Mar 16, 2012
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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:

or management failure.   Counterparty Credit Risk :The risk that a party to a derivative contract will fail to perform on its obligation. . human error. Operational Risk : The risk of losses occurring as a result of inadequate systems and control. Market Risk : The risk to earnings from adverse movements in market prices.

 .   Like any other contract. 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. they require a legal infrastructure. Legal Risk : The risk of loss because a contract is found not to be legally enforceable.  . Derivatives are legal contracts.

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

Introduction .

mining and engineering businesses and 15 subsidiaries. US oil trading subsidiary. b. b. 14th largest corporation in Germany. low market share. New entrant to US market. c. MG Refining & Marketing ( MG ) a. Conglomerate with interest in metal. a. Metallgesellschaft A. . Goal to develop a fully integrated oil business in US.G.

Heinz C. Dr. 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.

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

  . Guarantees a fixed margin to castle energy. Estimated volume 126.000 barrels/day ( 460M barrels over the next 10 years ). MGRM contacts to buy all the refined outputs from the castle energy for 10 years.

MG was obligated to a total of 52M barrels. to set the delivery schedule. . $3-$5 built in margin per barrel. relative to the price offered by its geographical competitors. 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. Guaranteed Margin : Under which MG agreed to make deliveries at a price that would assure a customer a fixed margin. MG developed 3 types of contract programs.

MG didn’t had a significant market share. to sell financial petroleum to the independent and quasiindependent retailers. MG spotted that what it thought was an innovative marketing strategy.  MG had No competitive advantage in its cost of supply.  MG was a New entrant to the U.  .S oil market.

  . MG`s protection to customer from the default risk. If energy prices rise above the contract price. counterparty can sell-back the remaining forward obligations for ½ differences between the near-term futures price and contracted futures price. MG embedded a cash out option on its supply contracts. which further creates liquidity risk for customer.

with downward adjustment for the delivered oil to keep 1:1 ratio. Key aspects of this strategy were: 1) Concentrated on the short dated futures and swaps.  2) Position had to be “rolled forward” monthly. MG`s total derivative position was 160M ( barrel for barrel )     The hedging strategy MG used was known as “ Rolling Forward” . . MG hedged the risk of rising oil prices with both short dated energy future contacts and OTC swaps.

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

 MGRM’s 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. Prices followed Contango Instead of Backwardian. the behavior of energy futures prices became most unusual in 1993.    .

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

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

Soybeans & copper Example:  .1) Assumptions of the MGRM’s Hedging strategy architects :  Key Question was whether the change was Temporary or persisted.

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

000 contract position in these contracts. MGRM reportedly holding a 55. Wherever the truth lies. MG's Supervisory Board shares the blame for this situation.  The Avg trading Volume is 15000 to 30000 contracts per day. 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.   .

was chairman of MG’s board of supervisors at the time. Deutsche Bank executive. Deutsche Bank was not only a creditor to MG but also one of its largest shareholders. notably the late Merton H. Unrealized Gains would have resulted in 170 Million Loss Rather than 1. Ronaldo Schmitz. a Nobelwinning economist. argued that Deutsche Bank was to blame because it panicked. Miller.    .5 Billion . Experts in derivatives.

  . The management of MG would have benefitted from implementing the recommendations put forth in the Group of Thirty Derivatives study. but the blatant disregard for these principles cost MG a mere $1. Every Few Weeks Companies lose money by either speculating or by having lack of hedge ratio understanding. These recommendations are basic.5 billion.

 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. .

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