Economic Capital for Market Risk

David R. Koenig

In December 1993, Metallgesellschaft AG revealed that a subsidiary has accumulated paper losses of nearly US$1.5 billion from a hedging programme designed to offset the risks of long-dated forward contracts it had sold. Because they were unable to meet the cashflow requirements of the hedges, the positions and programme were liquidated, resulting in the realisation of the losses and a collapse in Metallgesellschaft’s stock price.

In 1994, as market prices for mortgage-backed securities changed radically, Askin Capital Management maintained valuations at theoretical levels, substantially above trading prices. Forced liquidations revealed the disparity, spawning the phrase “Askin for mercy” and leading four funds with over US$600 million in assets to bankruptcy.

At end of September 1998, LTCM, a multibillion-dollar hedge fund, was teetering on the brink of default due to continued adverse and extreme market movements. To avoid the threat of a systemic crisis in the world financial system, the Federal Reserve orchestrated a US$3.5 billion rescue package from leading US investment and commercial banks and the unwinding of a substantial portion of the positions held.

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