Metallgesellschaft’s Case

[notjusttp]

Hi David,

I went thru this case and also your and Jacks discussion on the same but i could not get 1 simple concept clear. can you pls help me with a simple example

1) MG had Long position in short term futures.

2) Markets went into Contango.

3) Now if MG is in a long position he is locked it at a price say 20$.

4) Market goes into contango i.e futures price is above spot lets assume now its 25$.

5) Then actually MG is gaining as it had bought futures at 20$ and now the same is 25$

How is MG losing? Can you pls explain me in layman terms with the same example as i gave as i got utterly confused after i went thru the earlier thread.

Thx & Rgds
Amit

 

[David Harper CFA FRM]

Hi Amit,

This previous thread is wordy, but here is link for reference. Market starts in backwardation; e.g., spot (Jan) = $24 and forward(Dec) = $20. Assume MG takes long position in F(dec) @ $20

...imagine now it is March...
Market shifts to contango (will simulate MG's contango, which specifically was: spot decreases more than forward):
e.g., spot (March) $15 and forward (Dec) = $18

...now just assume that forward curve is "static"
then the long forward @ $20 must be rolled over into a loss
assuming foward converges to spot, then under contango, forward (Dec) is dropping to converge with spot of $15
loss on forward is converging to $20 - $15

more generally, the key ideas are:

1. The assumption that the basis (spot - futures) converges to (a zone of) zero as term to maturity declines, and
2. Under backwardation (contango), the roll return is postive (negative)

e.g., if forward (Dec) = $20 and spot (Jan) = $30, we have backwardation and, if we assume static forward curve, what happens to the forward price over time? It converges to the spot, so it is increasing to converge, and long forward position are "rolled over" a profit

Thanks, David

 

[notjusttp]

Hi David,

Thanks for the brilliant explanation in layman's terms..Now the concept is crystal clear to me. I missed the point that Spot was also moving and the contango or backwardation is not a static concept but it is a dynamic situation which keeps on happening on a month on month basis..

U r the BEST ..Cheers..Amit

 

[David Harper CFA FRM]

Amit, re: dynamic: exactly! It "only" took me 3 years (I am totally serious) of repeated exposure to the MG case to feel like maybe I understand most of what Crouhy is saying David