Analytics Underlying the Metallgesellschaft Hedge: Short Term Futures in a Multi-period Environment.

In a highly publicized example, a marketing and refining subsidiary of Metallgesellschaft controlled short term derivative positions reportedly equivalent to 160 million barrels of oil, 80 times the daily output of Kuwait. Presumably, the short term positions were taken to hedge oil contracts to customers over an extended period. This paper develops the analytics underlying the hedging of long term flow commitments with short term futures contracts. Its contributions includes the determination of minimum variance hedging paths for multiperiod flow portfolios and the evaluation of both period-by-period and end-of-horizon volatilities under various hedging schemes. The analysis allows for basis risk, non-zero cost-of-carry, and spot diffusion processes that have a non-zero market price of risk. The results are developed in the context of an efficient market and standard equilibrium pricing models. Copyright 1999 by Kluwer Academic Publishers