Mgrm

• Case Overview

I have chosen case study 2-Metallgesellschaft AG for my first case study assignment. After overviewing the whole case, in my opinion, the company’s initial idea and the kernel strategy is well enough to hedge the risk. However, they may have a not very well prediction of the market of crude oil.

The MGRM began to sell contracts to supply gasoline, heating oil, and diesel fuel at fixed prices over 5- and 10-year periods. This is the long-term forward as mentioned below in the case. And at that time, the scale of such market increased very fast. So that MGRM decided to hedge the exposure using gasoline, heating oil and crude oil futures contracts on NYMEX. These are the short-term futures as mentioned below in the case. Also they entered some OTC swap to hedge the exposure.

The kernel strategy they used is ‘Stack-and-Roll’. The firm took long positions in futures contracts to cover its entire exposure. All positions are in the nearby futures contract. At the end of each month, the company closes out its position, and opens new long positions to cover its remaining exposure.

• Description of Knowledge Background

(Commodity derivatives, convenience yield, valuation of commodity derivatives, backwardation & contango, expectations hypothesis etc.)

In this case, the firm used commodity derivatives for hedging exposure. As we know, commodities differ from financial assets: they may be expensive to store and may generate a flow of benefits that are not directly measurable. The first dimension involves the cost of carrying a physical inventory of commodities. For most financial instruments, this cost is negligible but for bulky commodities, this cost may be high. The second dimension involves the benefit from holding the physical commodity. This flow is called convenience yield for the holder as mentioned in the case.

Expressed convenience yield as y per unit time, after storage cost, the forward price on a commodity should be given by...