Case Studies of Failed Hedges
Case Studies of Failed Hedges
Hedge failures have caused billions in losses and contributed to corporate bankruptcies. These failures typically stem from basis risk, model errors, governance breakdowns, or hedges that became speculative positions. Studying these cases reveals common patterns and lessons for more robust risk management.
Definition and Key Concepts
Causes of Hedge Failure
| Cause | Description |
|---|---|
| Basis risk | Hedge and exposure don't move together |
| Model error | Incorrect assumptions or calculations |
| Operational failure | Execution, documentation, or monitoring gaps |
| Governance breakdown | Unauthorized trading, inadequate oversight |
| Hedge becoming speculation | Position exceeds or outlives exposure |
| Liquidity crisis | Can't maintain or exit hedge position |
Failure Categories
| Category | Example |
|---|---|
| Economic loss | Hedge loses money while exposure also loses |
| Hedge ineffectiveness | Accounting test failure, P/L volatility |
| Counterparty failure | Hedge counterparty defaults |
| Legal failure | Hedge not enforceable |
| Reputational damage | Public disclosure of hedge losses |
Case Study 1: Metallgesellschaft (1993)
Situation
Company: Metallgesellschaft AG (German industrial conglomerate) Strategy: Hedge long-term oil supply contracts with short-term futures
Position:
- Sold 10-year fixed-price oil contracts to customers
- Hedged with rolling short-term NYMEX futures (1-3 months)
- Notional: 160 million barrels
What Went Wrong
Problem 1: Basis risk Long-term fixed price exposure vs. short-term futures hedge
Problem 2: Roll costs When oil curve in contango (futures > spot), rolling was expensive
Problem 3: Margin calls Oil prices fell from $20 to $14 per barrel in 1993
Cash flow impact:
| Component | Impact |
|---|---|
| Futures losses (MTM) | -$1.3 billion |
| Customer contracts (unrealized gains) | +$1.0 billion (est.) |
| Net economic position | -$300 million |
| Cash drain from margin | $900 million |
Outcome
- Parent company forced to provide emergency financing
- Hedge positions liquidated at worst time
- Total loss: $1.3 billion
- Management replaced
Lessons Learned
| Lesson | Application |
|---|---|
| Match hedge tenor to exposure | Use long-term instruments for long-term exposures |
| Plan for margin requirements | Size hedges within liquidity capacity |
| Consider basis risk | Analyze correlation between hedge and exposure |
| Avoid stack-and-roll risk | Diversify hedge maturities |
VaR Analysis (Hypothetical)
What VaR might have shown:
- Futures VaR (99%, monthly): $200 million
- Exposure offset VaR: $180 million
- Net VaR: $50 million (seemed manageable)
What VaR missed:
- Liquidity risk (margin calls)
- Roll risk (contango costs)
- Tenor mismatch basis risk
Case Study 2: Airlines Fuel Hedging (2008)
Situation
Companies: Multiple US airlines Strategy: Lock in fuel costs at $130-150/barrel levels
Positions (aggregate):
- Forward fuel purchases at $130-150/barrel
- Collar structures with put protection at $90-100
- Total notional: $20+ billion industry-wide
What Went Wrong
Problem: Oil prices crashed from $147 to $40 (2008-2009)
Hedge performance:
| Scenario | Airline Impact |
|---|---|
| Oil at $147 | Hedges profitable, but costs still high |
| Oil at $40 | Hedges locked in losses at $130, competitors pay $40 |
One airline's loss breakdown:
| Component | Amount |
|---|---|
| Fuel hedge MTM loss | -$600 million |
| Competitors' fuel savings | -$400 million (relative disadvantage) |
| Cash margin posted | -$300 million |
Outcome
- Several airlines reported billions in hedge losses
- Competitive disadvantage vs. unhedged competitors
- Some airlines filed for bankruptcy (multiple factors)
Lessons Learned
| Lesson | Application |
|---|---|
| Hedges lock in both directions | Can't benefit from favorable moves |
| Competitive position matters | Hedge if competitors hedge |
| Over-hedging dangerous | Don't hedge more than actual consumption |
| Collar structures have basis | Jet fuel vs. crude oil spread |
Hedge Ratio Analysis
Typical airline hedging:
| Timeframe | Recommended Hedge | Actual Hedge |
|---|---|---|
| 0-6 months | 80-100% | 100% |
| 6-12 months | 50-75% | 100% |
| 12-24 months | 25-50% | 75% |
| 24+ months | 0-25% | 50% |
Over-hedging created excess exposure to oil price declines.
Case Study 3: Ashanti Goldfields (1999)
Situation
Company: Ashanti Goldfields (Ghana gold producer) Strategy: Forward gold sales to lock in production revenue
Position:
- Forward gold sales: 10 million ounces
- Average forward price: $300/oz
- Production: 1.5 million oz/year
What Went Wrong
Problem: Gold prices spiked from $260 to $340 (25 central banks announced sales limit)
Margin impact:
| Component | Value |
|---|---|
| Forward MTM loss | -$400 million |
| Margin call | $280 million (immediate) |
| Production offset | Not realized until delivery |
Hedge ratio issue:
- Forward sales = 7 years of production
- Hedge extended far beyond reasonable visibility
Outcome
- Near bankruptcy
- Renegotiated hedge positions at significant cost
- Merged with AngloGold in 2004
- Management changes
Lessons Learned
| Lesson | Application |
|---|---|
| Don't over-hedge | Limit to 1-2 years of production |
| Consider margin requirements | Hedge only what you can fund |
| Mark-to-market risk | Production doesn't help margin calls |
| Governance controls | Board oversight of hedge size |
Case Study 4: Procter & Gamble (1994)
Situation
Company: Procter & Gamble Strategy: Interest rate swap to reduce borrowing costs
Position:
- "5/30" swap with Bankers Trust
- Complex formula tied to interest rate movements
- Notional: $200 million
What Went Wrong
Problem: Structure was highly leveraged and speculative
Swap formula (simplified): Pay rate = 5.3% × (30-year rate / 5-year rate)
When rate curve steepened, payment obligation exploded.
Loss calculation:
| Component | Impact |
|---|---|
| Swap MTM loss | -$157 million |
| Additional settlement | -$38 million |
| Legal fees | -$10 million |
Outcome
- Total loss: $195 million
- Lawsuit against Bankers Trust (settled for $78 million)
- Led to enhanced derivative disclosures
- Bankers Trust reputational damage
Lessons Learned
| Lesson | Application |
|---|---|
| Understand what you're trading | No complex structures without expertise |
| Hedges shouldn't add risk | Swap was speculative, not hedging |
| Documentation matters | Suitability obligations |
| Governance required | Board understanding of positions |
Summary of Common Failure Patterns
Risk Pattern Analysis
| Pattern | Frequency | Prevention |
|---|---|---|
| Over-hedging | High | Strict hedge ratio limits |
| Basis mismatch | High | Careful instrument selection |
| Liquidity squeeze | Medium | Margin requirement planning |
| Complexity | Medium | Simplicity in hedge design |
| Governance gaps | Medium | Board oversight, policies |
| Speculation drift | Low | Purpose restrictions |
VaR Limitations Highlighted
| Case | What VaR Missed |
|---|---|
| Metallgesellschaft | Liquidity, roll costs, tenor mismatch |
| Airlines | Competitive position, over-hedging |
| Ashanti | Margin liquidity, production timing |
| P&G | Leverage, complexity, tail risk |
Checklist and Next Steps
Pre-hedge evaluation:
- Define exposure clearly
- Match hedge tenor to exposure
- Limit hedge ratio appropriately
- Calculate potential margin requirements
- Assess basis risk
- Verify governance approval
Ongoing monitoring:
- Track hedge ratio vs. exposure
- Monitor margin utilization
- Assess basis risk evolution
- Review hedge effectiveness
- Report to oversight committee
Warning signs:
- Hedge exceeds underlying exposure
- Hedge tenor extends beyond exposure
- Complex structures not fully understood
- Margin calls straining liquidity
- Basis widening unexpectedly
- Hedge profits exceeding exposure losses
Related articles:
- For automation, see Automation and Monitoring of Hedge Ratios
- For terminology, see Glossary: Risk Management Terms