SHS Web of Conferences 188, 01004 (2024) https://doi.org/10.

1051/shsconf/202418801004
ICDDE 2024

A study of the correlation between volatility and risk

diversification control in options and futures markets
Chengfan Yang1,*
1
School of Finace and Investment, Guangdong University of Finace, Guangzhou, Guangdong Province, 510521, China

Abstract. With the continuous development of financial derivatives, many enterprises increasingly prefer
using financial derivatives such as options and futures when hedging their risks. However, in the process of
using them, many enterprises do not use them as a tool for risk hedging but instead use them for hedging or
even try to achieve short-term wealth appreciation through options and futures trading, which is contrary to
the original intention of enterprises to use financial derivatives. At the same time, financial derivatives are
affected by market volatility. Without professionals to carry out risk control, it will be a double-edged
sword; using bad will become a sword to stab at the enterprise. This paper adopts the illustrative method
and literature research method to analyse the impact of market volatility and the importance of risk control
of options futures by taking the example of the German metal company trying to hedge through options
futures in 1993, which ultimately caused the enterprise to fall into difficulties.

1 Introduction platforms has revolutionised futures and options trading,

making it more efficient and convenient. Overall, the
Modern options and futures are indispensable financial origins of modern futures and options markets can be
derivatives used for risk control in today's financial traced back to the 19th and early 20th centuries in the
market trading. In modern times, futures and options U.S. Over time, these markets have continued to grow
trading has been further developed and standardised to and become an integral part of the global financial
become important tools in the financial markets. The market. Although risk is hedged due to options futures,
futures and options market provides producers, many firms in the market still fail to hedge or control
consumers, and investors with a platform for risk risk due to market uncertainty. Due to the uncertainty of
hedging, price discovery, and speculative trading. It the market, options and futures also have large market
plays an important role in the stability and development volatility, and many firms face great market uncertainty
of the modern economy. Modern options futures trading while using options and futures for risk hedging [1].
began around the end of the 19th century and the Therefore, studying market volatility and risk control of
beginning of the 20th century with several landmark options and futures is important to enterprises and can
events. The Chicago Board of Trade (CBOT), founded in help them create better risk control strategies for their
1848, was one of the world's first futures exchanges. conditions. It is of great business value for individual
Initially, the CBOT was primarily designed to provide companies to avoid unnecessary costs and reduce risks.
trading in agricultural futures to help farmers and The analysis by Frank Asche et al. concluded that
merchants hedge their exposure to price fluctuations. As market volatility is divided into implied volatility and
industrialisation grew, so did the demand for industrial actual volatility, the use of implied volatility to predict
commodities and metals in the financial markets. In future changes in commodity prices, and the relationship
order to hedge against fluctuations in the prices of these between implied volatility and actual volatility. The
commodities, futures exchanges began to offer more research results show implied volatility can be used as an
types of futures contracts, including metals and energy. effective risk management tool to help traders better
Options trading is a relatively recent development but control the risk of futures and options trading [2].
has a long history. In the early 1900s, options trading Meanwhile, a dynamic hedging strategy based on
began to take off on exchanges such as the Chicago stochastic volatility is proposed by Man-man Zhu et al.
Derivatives Exchange (CME). Options contracts give 2021, which can effectively reduce trading risk in futures
investors the right to buy or sell the underlying asset at a and options trading. The research results show that the
specific price at a certain time. In 1973, the Chicago strategy can achieve good risk management effects under
Board Options Exchange (CBOE) was established, different market conditions [3]. This shows a strong
which marked the formal formation of the options correlation between market volatility and risk control
trading market. With the development of computer management. Not only that, market volatility can also
technology, the emergence of electronic trading predict the risk faced by the enterprise and make a more

*
Corresponding author: [email protected]
© The Authors, published by EDP Sciences. This is an open access article distributed under the terms of the Creative Commons Attribution
License 4.0 (https://creativecommons.org/licenses/by/4.0/).
SHS Web of Conferences 188, 01004 (2024) https://doi.org/10.1051/shsconf/202418801004
ICDDE 2024

reasonable response program. Lars Stentoft 2015, futures position and cancel the supply contract. This
studied the impact of market volatility on futures and decision occurred at the most undesirable time, causing
options trading and proposed a trading strategy based on MGRM to forgo future supply contract gains and pay
implied volatility, which can help traders better respond liquidated damages. It is estimated that MGRM lost $1.3
to changes in market volatility and risk management [4]. billion on the futures and swaps trades, more than half of
Most scholars have only studied the arbitrage of option Deutsche Metallbau's capital, and nearly caused the
futures, and only a few have studied the correlation company to go bankrupt.
between market volatility of option futures and risk
control management and the impact between the two.
This paper first takes the failure of futures trading of 3 Analysis on the problems
a German metal company in 1993 as a case to analyse
the impact of market volatility on risk control, which 3.1 The status of investments in futures trading
shows that option futures hedging risk does not only
look at the company itself but also needs to be analysed In addition to trading spot, futures, and options on
from the macro point of view of the market. The case is commodity exchanges for its own industrial group,
then used to illustrate the risks inherent in options and Deutsche Gesellschaft für Metallwirtschaft (DGM) also
futures and the impact of market volatility on risk offers brokerage services to other businesses engaged in
control, showing that risk control is not 100%. Finally, hedging, arbitrage, and speculative trading. It also trades
the theories provide insights and warnings to companies in the over-the-counter market with counterparties acting
that need to control risk. as market makers. Oil commodities trading is the area of
expertise for Deutsche Metals AG's U.S. subsidiary, MG
REFINING AND MARKETING (henceforth referred to
2 Case description as "Deutsche Metals"). Deutsche Metals signed a deal to
trade oil commodities with a client in the summer of
The case of Deutsche Metallbau is a story of failed risk
1993. "MG REFINING AND MARKETING signed a
management in financial derivatives trading. German
long-term supply agreement with its client in the summer
Metals is a long-established industrial group dealing in
of 1993.
metals, energy, and other products. Its U.S. subsidiary,
This was unique because it combined a special
MGRM, entered into several long-term supply contracts
supply contract with a financial derivative element.
with a number of oil retailers in 1993, promising to
"Deutsche Metals committed to providing aviation fuel,
supply petrol, heating oil, and jet fuel at fixed prices.
heating oil, and automotive oil to oil retailers in the
These contracts also included an option that allowed the
United States (henceforth referred to as "customers") at a
retailers to terminate the contracts and receive cash
fixed price for a period of ten years, with a portion of the
compensation if the market price was higher than the
supply to be delivered in regular quantities and a portion
contracted price. In order to hedge against the risk of
to be delivered at a time to be decided by the customer.
rising oil prices, MGRM employed a hedging strategy in
The remaining portion of the supply will be delivered at
the futures and storefront markets by buying large
the user's decision. Unlike typical long-term contracts
quantities of short-term oil futures contracts and swaps
that adjust for inflation, the contract ensures a fixed
that it continually rolled over. In this manner, MGRM
supply price for an extended period. Delivery time and
hoped to lock in future profits while taking advantage of
quantity are uncertain. The financial derivative
the market's law of spot premiums to earn basis
component gives the customer the right to choose
differentials. However, MGRM's hedging strategy
whether to require Deutsche Metals to pay the difference
encountered a series of problems that led to large losses.
between the spot price and contract price for the entire
First, in late 1993, there was a sharp decline in oil prices,
10-year contract term. If the global oil spot price exceeds
causing MGRM to incur large floating losses on its long
the contract price, the customer can choose whether to
futures contracts and swap agreements. Although future
force Deutsche Metals to settle the contract by paying
gains on the supply contracts could offset these losses,
the difference in cash for the undelivered oil.
MGRM was required to make significant margin calls
At the end of the contract, the contract was priced at
under the day-ahead settlement rules. Secondly, the spot
$3 to $5 above the spot market price, which was
premium pattern of the market has changed to a spot
attractive to the supply side. And crucially, German
discount situation, where the spot price is lower than the
Metal Construction had to accept the terms of the
futures price. This means that MGRM has to pay for
contract. Subsequently, Deutsche Metallbau was
closing losses when it rolls over and post in cash to
confident in relying on its extensive trading experience
cover the change in basis differentials. Again, because
in the global commodity markets and was even more
MGRM's futures position was too large, accounting for
assured of its technical capabilities in financial
20% of the total crude oil futures position on the New
derivatives trading. As a result, German Metal
York Mercantile Exchange (NYMEX), the exchange
Construction developed a hedging strategy in an attempt
decided to cancel MGRM's "hedging privilege" and
to hedge against the risk of changes in the price of oil by
double the margin. This put further pressure on MGRM.
purchasing standardized futures contracts for oil on the
Finally, the Supervisory Board of Deutsche Metallbau,
New York Mercantile Exchange and swapping them on
which did not understand MGRM's hedging strategy and
the over-the-counter market, thereby transferring the
regarded it as speculative, decided to close out MGRM's
price risk arising from the contracts with its customers.

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SHS Web of Conferences 188, 01004 (2024) https://doi.org/10.1051/shsconf/202418801004
ICDDE 2024

Although the firm's approach was theoretically and and recommends that rigorous testing must be carried
practically appropriate, the hedging strategy failed. out before practical applications of hedging design. In
the case of Deutsche Metallbau, the hedging design
models did not undergo rigorous testing, and there were
3.2 Reasons for analysis based on the
significant problems with key technical parameters such
characteristics of options futures trading
as coverage, term matching, and risk prevention of basis
When the contract came up for renewal, Deutsche swaps. In addition, potential liquidity risks and credit
Metallurgical had to swallow the cost of closing the risks were not properly handled, which seriously affected
position and inject cash to bridge the widening spread the evaluation and implementation of the hedging
between spot premiums and spot discounts. At this strategy.
critical juncture, the New York Mercantile Exchange Finally, issues that arise in the later stages of futures
(NYMEX) proposed doubling initial margins for oil management are partly attributed to the limitations of
futures contracts, further compounding Deutsche traditional accounting techniques. Traditional accounting
Metallurgical's financial woes. With cash flow techniques cannot timely reflect the profits and losses of
constraints and limited financial resources, the company trading positions.
struggled to meet the exorbitant margin requirements It is important for businesses to understand how to
and the cost of rolling over contracts. Creditors and manage the financing and profit/loss issues associated
shareholders began to lose faith, reluctant to extend with hedging. Once the hedging position is established
further loans or invest. This uncertainty led to major and the design is perfect, the loss on one side will always
shareholders questioning the company's resilience in be balanced by the profit on the other side, regardless of
weathering the crisis. As a result, Deutsche market price changes. However, traditional financial
Metallurgical—once a proud pillar of the German accounting statements often fail to provide a clear and
industrial landscape—teetered on the brink of complete picture of the true profit, loss, and risk
bankruptcy, sending tremors throughout the industry. associated with derivative transactions. This, coupled
with the fact that many managers, investors, and
creditors may not have a comprehensive understanding
3.3 Causes of the problem of the concept of hedging, can lead to misinformation
and only focusing on the loss side.
Firstly, Deutsche Metallbau lacks a thorough
Therefore, it is essential for business stakeholders to
understanding of the nature of futures trading. As a
gain a better understanding of hedging methods and their
highly technical activity, financial derivatives trading
implications. In the case of Deutsche Metallbau, a lack
involves various stages such as design, trading, clearing,
and performance, which poses new management of communication between management, shareholders,
challenges for companies that produce and consume and other stakeholders about hedging long-term oil
supply contracts led to management conflicts that
these contracts. It should be noted that financial
ultimately had catastrophic consequences. To avoid such
derivatives trading has dual characteristics: it can be
situations, businesses need to ensure that all relevant
used for hedging to avoid risks, and at the same time, it
parties are well-informed and understand the purpose
can also be a tool for speculation by taking on high risks
to pursue high returns. The dual nature makes it and risks associated with hedging strategies [7].
particularly difficult to accurately judge the nature and
risks of a trade [5]. Many cases have shown that some 4 Suggestions
people often trade speculatively in the name of hedging
to gain personal benefits. Therefore, senior management
must have sufficient professional knowledge or rely on 4.1 Establish a risk management system
the support of professional technical personnel to make
The objective of risk management optimisation of the
independent and objective judgments on the nature of
OTC commodity options business of the enterprise is to
derivative transactions that could significantly impact the
establish a comprehensive proactive and intelligent risk
enterprise's overall risk [6].
management system through the joint participation of the
However, Deutsche Metallbau demonstrates a clear
enterprise management and all employees, to ensure that
speculative mentality in futures trading, completely
the OTC commodity options business of the enterprise
ignoring market volatility. The company lacks sufficient
complies with the relevant laws and regulations,
technical support to hedge risks, and senior management
regulatory provisions, self-regulatory rules and
handles futures trading too casually, ultimately leading
requirements of the enterprise regulations, and to realise
to huge losses.
the maximisation of the value of the enterprise is to
Using financial derivatives for hedging usually
promote the enterprise on the premise that the overall
requires the help of complex mathematical models. The
risk is measurable, controllable and affordable, to
key is to accurately measure the correlation between the
Comprehensive implementation of development
current price of goods and the price of derivative
strategies and the achievement of business objectives, to
contracts selected. If the correlation measurement is
promote the company to continuously strengthen the
inaccurate, the risk of hedging failure will increase. The
awareness of risk management, take the initiative to
G30 has conducted in-depth research on the technical
form a good risk management culture, to ensure that the
level and issues of global financial derivatives trading
regulatory requirements, the group's decision-making

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SHS Web of Conferences 188, 01004 (2024) https://doi.org/10.1051/shsconf/202418801004
ICDDE 2024

and deployment and the company's business comprehensively to plan and manage the development of
management objectives are effectively implemented [8]. enterprises.
It is necessary to objectively analyse the current Fourth, introducing risk management accounting:
situation of the enterprise's economic operation. On this Traditional accounting focuses only on historical data,
basis, should be hired in options and futures trading and ignoring future risks and uncertainties. Introducing risk
risk avoidance of relevant technical personnel, focusing management accounting can help companies better
on the relevant tail hedging strategy, not only by the understand future risks and uncertainties and thus better
senior management's own decision to make decisions plan and respond to future challenges.
that affect the operation of the entire enterprise [9]. At
the same time, a large enterprise should retain its
customers and have the right to know the company's 5 Conclusion
decision-making, not to arbitrage for the company's This paper focuses on the collapse of the futures hedging
senior management, which can only play a negative role strategy of Deutsche Metallbau in 1993 as an example to
in the life of a company. analyse the impact of market volatility and risk control
of options futures on the whole strategy. Due to the
4.2 Professional staff to carry out risk control limited technological development in those years, some
and operations of the tools for risk control were not yet intelligent; at
the same time, the detailed nature of the traditional
Facing up to the nature of the use of options and futures accounting techniques also contributed to the disaster,
in the enterprise, the use of options and futures needs to which led to the solution strategies proposed in this
be related to professional staff to carry out risk control paper. Many techniques are now being realised, but the
and a series of operations. Critical attitude to the relevant revelations are still significant for most who use option
opinions of senior management, the board of directors of futures for risk hedging. These strategies can reduce, in
the enterprise should be independent of a new regulatory most cases, the subjective and objective risks associated
authority to manage it, and at the same time to give high with implementing risk controls that companies can
authority to isolate it from the senior management, can address. On this basis, they can also remind companies
not influence the impact of relevant decisions, so as to that when using options futures, they should be clear
ensure the normal operation of the enterprise and the about the purpose of their use and follow the basic
rights and interests of shareholders and customers. It is principle of maximising the company's interests rather
also important to utilise market volatility, supplemented than simply hedging for a small group of people.
by the appropriate use of relevant data tools, for risk However, due to the diversity and uncertainty of the
control management [10]. market, many factors are not considered in other
conditions ideal to solve the existing problems.
4.3 Improvement of accounting standards and
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