Case Metallgessellschaft Essay

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1. Explain the hedging strategy of Metallgesellschaft After the Gulf War in 1991 oil prices fell significantly; as a result demand for forward oil contracts increased dramatically. Forward contracts are agreements between a buyer and a seller who are both obliged to perform against a certain price at a certain agreed upon date in the future. The goal of forward contracts is to lock in a certain price for a commodity, in this case oil, to avoid large price fluctuations in the future. MG Corp, MG AG's US subsidiary, was a major seller of these contracts, which in 1993 resulted in obligations to supply nearly 160 million barrels of oil over the next ten years. Of course, there was a risk involved in delivering these forward contracts as in case the oil price would increase, MG Corp would make huge losses This is where the hedging strategy comes in; MG Corp decided to use futures contracts to hedge their positions in forward contracts. A futures contract is almost the same as a forward contract, as again, a buyer and seller agree on a certain price for delivering the underlying commodity in the future. However, futures are standardised and traded on exchanges. Furthermore, futures are marked to market on a daily basis, which is why a margin account needs to be kept by both parties involved In this margin account the daily marking to market is settled, which minimizes the chance of default and failure of payment of each of the parties. However, it also adds the risk that firms need extra liquidity to handle a sudden cash outflow prior to expiration of the futures contract. In the case of MG Corp, the company sold oil products at fixed prices over long periods of time into the future and tried to hedge this exposure using short-term contracts, the so-called 'rolling-stack' strategy. MG Corp was hedging against the risk that oil prices would increase over this

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