Question 2. [9 marks]

Background: Metallgesellschaft AGwas formerly one ofGermany's largest industrial conglomerates based inFrankfurt. It had over 20,000 employees and revenues in excess of 10 billion US dollars. It had over 250 subsidiaries specializing in mining,specialty chemicals(Chemetall),commodity trading,financial services, andengineering(Lurgi). In 1993, the company lost 1.3 billion dollarssuffering from flawed long hedge strategy in near term futures contracts that was meant to protect against forward sales commitments. A fall in spot prices forced margin calls for the company and the contracts were closed at a loss. Subsequently, the spot price increased and the company suffered even greater losses covering its customer commitments. It is debated whether the company was speculating after unwinding the long futures hedge since they became essentially exposed or naked against their forward customer commitments.- from Wikipedia [https://en.wikipedia.org/wiki/Metallgesellschaft]

The following illustrates how important it is to consider tailing factor in taking a correct hedge strategy. 0.5 marks for filling each blank>

Suppose the current spot price is $3. With 50 percent of the probability, the spot price will increase or decrease by 1 dollar for first year and then remain the same as shown in the graph below.