Hedging Strategy. The case of Metallgesellschaft Refining and Marketing

Essay from the year 2013 in the subject Business economics - Operations Research, grade: 7.5, Maastricht University, language: English, abstract: Specializing in mining, commodity trading, specialty chemicals and financial services, Metallgesellschaft AG (hereafter MG) was one of largest German Industrial Corporation, with over 20,000 employees and an average revenue of $10 billion annually, who's headquarter was located in Frankfurt. The financial statements presented by the board in December 1993 reported that the U.S subsidiary Metallgesellschaft Refining and Marketing (hereafter MGRM) suffered huge derivative-related losses of over $1bn dollar. Due to the gravity of the losses, it caused a serious threat of bankruptcy to the parent company MG. Many theories try to explain the management failure at MGRM that caused the huge speculative loss. The commonly accepted theory is that the management and board of MG were ill informed about its subsidiaries activities and speculation, making them vulnerable for making irrational decisions, which is represented by their overreaction, in particular to liquidize the outstanding contracts, which MGRM had with their clients. Many critics believe this heavily amplified the risk exposure of MGRM and caused the loss to increase in the long run. However, other empirical studies and economists argue that the liquidation of the contract was the best-case scenario at that time, but that the speculative contracts should have been constructed differently. Whether the board and management team responded properly to the situation or not, both parties tend to agree with the fact that MGRM speculated with a different reason than normally assumed in financial markets. Namely, considering its expertise and global influence in the oil market, the assumption that MGRM used derivatives to exploit arbitrage in the market seems commonly accepted. In other words, MGRM did not hedge to minimize risk, but to maximize profits. This strategy might have played a role in the cause of the losses MGRM made in the following years after the hedging program was initiated. This case will provide an overview of the business idea of MGRM and the hedging strategy that was initiated to mitigate the risk. Furthermore, this case will provide a brief overview of Culp and Miller's opinion about MGRM hedging strategy. Substantiated by this article, this paper will provide an overview of the risks of the hedging strategy initiated by MGRM. Lastly, the management response will be analyzed in more detail after which a short conclusion is provided.