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Today's hot transaction is often tomorrow's pariah. It seems derivatives are quickly acquiring the same kind of opprobrium that was assigned to junk bonds a number of years ago. However, there is as much to learn and profit from the trials of the markets with derivatives as there was in the wake of the great junk bond crash.
The financial technology of unbundling and hedging risks through the use of derivative strategies has made great strides in the past decade. Nevertheless, there are still critical implementation issues that can provide sophisticated investors with expensive lessons if too much attention is paid to the academic concepts of hedging theories and not enough attention paid to the details of managing and structuring a complex set of transactions through time with less than perfect markets.
The important features of the transactions on Metallgesellschaft's books that eventually led to financial disaster were:
* Large short positions in long-dated forward contracts -- that is swaps.
* Long positions in futures contracts that were closely comparable to the forwards except for maturity.
The futures positions established as a hedge for the forwards were short-dated. This was the case for the simple reason that the futures markets for most commodities have relatively little liquidity or fluidity beyond the first few contract dates. To hedge large quantities of such a commodity in a short period of time, it maybe feasible to do so only with short-dated futures. In its simplest form, such a hedge is merely a summation or stacking of all of the quantities of the forward exposures, which are often monthly amounts distributed over 60 or more periods. The futures and forward contracts in Metallgesellschaft's case concerned energy, but the particular commodity or financial instrument is immaterial. Global investors using stock index futures to neutralize their equity portfolios versus general market fluctuations can encounter the same problems that Metallgesellschaft faced -- though the positions described for Metallgesellschaft are the reverse of those such an investor would be establishing.
Hedging plan
The hedging plan will call for reducing the hedge each month by the amount of the forward exposure that is maturing that month and rolling the rest into the next month's futures contract, which invariably will acquire the liquidity and...