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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

Which statement best captures a lesson on model risk from Metallgesellschaft Refining and Marketing (MGRM) in 1993?

MGRM's stack-and-roll hedge model ignored funding liquidity. When oil prices fell, margin calls on the short-dated futures drained cash even though the long-term contracts gained value, showing that a hedge can be economically sound yet fail on liquidity and rollover risk.

  1. AA hedge ratio model that ignored funding liquidity from margin calls on stack-and-roll futures hedges exposed the firm to large cash drainsCorrect
  2. BUsing forwards instead of futures eliminated all basis risk
  3. CThe hedge failed because the firm had hedged too little of its long-term fixed-price contracts
  4. DThe losses resulted from a rogue trader hiding positions in an error account

Explanation

MGRM sold long-term fixed-price oil contracts and hedged with short-dated futures rolled forward. When prices fell, margin calls created huge cash needs even though the contracts gained economically. The hedge model overlooked funding liquidity and rollover risk. It was not under-hedging via a rogue trader.

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