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Lecture 4:
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
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 .
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
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
Backwardation: spot>future
Contango: spot<futures
Losses
Margin calls
Liquidity issues German accounting standards
Operational Risk
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
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 Lets use an example to find the value of call option at expiration
35 30 = 5
OR
Or
The extra time increases the probability of profit for option holder and loss for option writer
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
S = Current stock price E = Exercise price of call r = Annual risk-free rate of return, continually compounded 2 =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
P = Price of put E = Exercise price C = Value of call option S = current market price of the underlying asset
E P rt S C e