Title: Metallgesellschaft's hedging revisited: A bootstrap reality check
Authors: Tyler Brough - Utah State University (United States) [presenting]
Abstract: The derivatives trading episode of Metallgesellschaft (MGRM) is now more than two decades old. The case still captures great interest in research and teaching as it pertains to lessons learned from using derivatives for risk management. The episode spurred much early academic research, much of it contradictory. It has been previously defended MGRM's hedging practices as essentially sound. At the same time other authors provide evidence that MGRM's hedging was excessively speculative relative to a minimum-variance benchmark. We bridge the gap between this literature by providing more direct evidence. We do this by applying a nonlinear vector error correction model with GARCH to establish the dynamic properties of spot and futures prices. Having established these properties and the nature of the cointegrating relationship, we then employ White's bootstrap Reality Check to directly compare Pirrong's optimal BAG minimum-variance hedge ratio and MGRM's one-for-one hedging ratio strategy. Further, we utilize the simulation to address the liquidity risks faced by MGRM and how they might have been better managed. We find evidence that MGRM's hedging was sound but that by utilizing a synthetic funding strategy they could have improved their liquidity risk substantially.