This document provides background information and details about Metallgesellschaft AG's (MG) expansion into derivatives trading and the massive losses it experienced. It discusses how MG began selling long-term fixed-price forward contracts for petroleum in the early 1990s. By late 1993, it had accumulated forward contracts equivalent to 160 million barrels. However, MG also took large long futures positions that year, which exposed it to risks from changing price relationships in futures markets. Significant losses from these positions due to falling prices led to margin calls and liquidity issues, contributing to MG's cash flow crisis.

1. Metallgesellschaft AG:
A Case Study
Lecture 4:

2. Background
• Metallgesellschaft AG, or MG, was a German
conglomerate
• MG, a traditional metal company, has evolved in the
last four years into a provider of risk management
services
• MGRM's expanded venture into the derivatives world
began in 1991 with the hiring of Mr. Arthur Benson
from Louis Dreyfus Energy
• It was Benson's strategy that eventually contributed
to the massive cash flow crisis that MG experienced

3. The Deals
• MGRM committed to sell, at prices fixed in 1992,
certain amounts of petroleum every month for up to
10 years
• These contracts initially proved to be very successful
since, in some cases the profit margin was around $5
per barrel
• By September of 1993, MGRM had sold forward
contracts amounting to the equivalent of 160 million
barrels
• .

4. Cause
• In the fall of 1993, Metallgesellschaft went long
on approximately 55 million barrels of gasoline
and heating oil futures
• At that time, the average trading volume for gas
was only between 15,000 and 30,000 barrels
• By December of that year, Metallgesellschaft had
long positions in energy derivatives equivalent to
185 million barrels of oil

5. Hedging Strategy
• Short forward. In 1991, Metallgesellschaft wrote
forward contracts of up to 10 years.
• Futures: Metallgesellschaft used another strategy
to hedge the risk of upward price movements: it
entered into huge positions in the futures market
for each month
• then stacked and rolled over these contracts every
month

6. • Backwardation: spot>future
• Contango: future spot<futures
• Losses
• Margin calls
• Liquidity issues
• German accounting standardards

7. Risk areas affected
• Basis risk
• Dealing risk: huge positions
• Liqudity risk
• Operational Risk

8. Some more jargons related to options
• If price of the common stock S exceeds the
exercise price of a call, E, the call is said to be in
the money
• If the price of common stocks is less than the
exercise price, it is said to be out of money

9. Intrinsic Values
• If a call is in the money, it will have positive
intrinsic value.
• Intrinsic value is equal to the difference between
current price and exercise price
• Example: FFC current price is Rs.65, a call option
on FFC is Rs.60, the option is in the money
• IV = 65-60 = 5

10. Pricing an option
• Pricing an option means “finding the amount that
you pay to have the right/option”
• Or pricing an option is finding the “fair” value of
the agreement
• “fair” means the value that precludes any
arbitrage opportunity
• Let’s use an example to find the value of call
option at expiration

11. Pricing call option at expiration
• Suppose you own a call option on one share of
PTCL stock with a strike price of Rs. 30
• Suppose that at expiration one share of PTCL
trades at Rs. 35
• What should be the minimum price of this call
now?

12. Price of call option
• Minimum price should be
• 35 – 30 = 5 OR
• Market price – Exercise Price Or
• S – E which is equal to Intrinsic value
• In other words, price of call option can never be
lower than intrinsic value

13. Determinants of option prices
• 1. Exercise Price
• An increase in the exercise price reduces the value of the
call
• In the previous example, if exercise price was 32 instead
of 30, the value of the call option will be
• 35 – 32 = 3 instead of 5

14. • Expiration date : the higher the maturity, the
higher will be the value of a call option
• The reason is that the option holder has more
time to exercise the option
• The extra time increases the probability of profit
for option holder and loss for option writer
Determinants of option prices

15. • Stock Price: Other things being equal, the higher
the stock price, the more valuable the call option
will be.
• In our earlier example, if current market price of
PTCL share was Rs. 40, then option value would
have been
• 40 – 30 = 10 in stead of 5
Determinants of option prices

16. • The Variability of the Underlying Asset
• The greater the variability of the underlying asset,
the more valuable the call option will be
• Greater variability can subject the option writer to
higher losses, this is why option writer will need
higher premium for giving such option
Determinants of option prices

17. • The Interest Rate
• Call prices are also a function of the level of interest
rates.
• Buyers of calls do not pay the exercise price until they
exercise the option.
• The ability to delay payment is more valuable when
interest rates are high and less valuable when interest
rates are low.
• Thus, the value of a call is positively related to
interest rates.
Determinants of option prices

18. The Black-Scholes Model for valuing
options
• Black-Schole model uses the five variables to
value non-dividend paying call option

19. • S = Current stock price
• E = Exercise price of call
• r = Annual risk-free rate of return, continually
compounded
• δ2 =Variance (per year) of the continuous return on
the stock
• t = Time (in years) to expiration date
• N(d)= Probability that a standardized, normally
distributed, random variable will be less than or
equal to d

20. • The black-shcoles model formula for put is as
under
• P = Price of put
• E = Exercise price
• C = Value of call option
• S = current market price of the underlying asset
C
S
e
E
P rt
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