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Amaranth Collapse

Essay by   •  December 11, 2017  •  Case Study  •  1,123 Words (5 Pages)  •  957 Views

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Background of organization

Amaranth Advisors LLC was an American private hedge fund founded in 2000 and headquartered in Greenwich, Connecticut. The firm was founded by Nicholas Manouis and specialized in convertible arbitrage in the early 2000’s. However, Canadian trader Brian Hunter was brought on board in 2004 and the firm switched its focus to energy trading in the natural gas market.1 The fund garnered an impressive reputation and proceeded to receive large investments from pension funds such as the San Diego Employees Retirement Association. From January 2006 to August 2006 the fund grew from $7.4 billion to $9.2 billion in assets.2 However, the firm became notorious for losing over $5 billion by trading natural gas futures over a short period of time, and now regarded as one of the biggest hedge fund failures in history.

Analysis of Derivatives Strategy and Cause of Financial Loss

The key derivatives strategy that resulted in Amaranth’s demise is the natural gas calendar spread strategy that aims to benefit from weather conditions in different times of the year. The natural gas market in the mid 2000’s provided traders with the opportunity to generate significant returns due to a volatile market and the increasing demand for natural gas to generate electricity (Exhibit 1). Hunter entered speculative positions using natural gas futures contracts on the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE). Specifically, the strategy aimed to profit off the combination spread between March and April 2007 contracts. In 2005, Hunter yielded profits by going long on winter natural gas futures contracts and short on

1 Morgenson, G. & Anderson, J. (2006). “A Hedge Fund’s Loss Rattles Nerves”. The New York Times. 2 McCall, M. (2017). “Losing the Amaranth Gamble”. Investopedia.

non-winter futures contracts. Severe weather conditions during this time period such as Hurricane Katrina and Rita disrupted natural gas production and directly contributed to the rise in natural gas prices (Exhibit 2). As a result, the highly leveraged strategy Hunter pursued resulted in a profit of well over $1 billion for Amaranth. This natural gas investment represented 75% of the firm's profit during that period.3 In addition, the impressive results solidified Hunter’s reputation in the industry as a top trader and gave him the autonomy to take on additional risk in the future.

After August 2006, large financial losses occurred when Hunter’s highly leveraged bet on natural gas prices increasing failed to materialize. Weather conditions were less harsh than anticipated and the threat of another severe hurricane season was diminishing. This caused the inventory of natural gas supplies to build up, which ultimately resulted in lower gas prices. Halfway through September 2006, natural gas contracts fell and broke an important price support level of $5.50. Over the next two- week period, prices continued to drop another 20%, resulting in the firm’s cumulative loss of billions (Exhibit 3). The severity of these losses were derived from Hunter’s strategy of using borrowed money to double-down on his initial investments.4 Due to the success of Hunter’s previous trades, Amaranth gave him full discretion over the funds strategy. As a result, Hunter took on an excessive amount of risk in order to provide the same return as before. The fund became highly leveraged by borrowing money in order to initiate new positions, ultimately resulting in a leverage ratio of 8:1.5

3 Hilary, T. (2008). “A Case Study on Risk Management: Lessons from the Collapse of Amaranth Advisors”. Edhec Business School. 4 Sender, H. & Zuckerman, G. (2006). “What Went Wrong at Amaranth”. The Wall Street Journal.

5 Rimkus, R. (2017). ““Amaranth Advisors”. Financial Scandals, Scoundrels & Crises.

In addition, Amaranth had liquidity issues that further compounded the financial losses incurred from their trading strategy. In fact, at times Amaranth controlled up to 40% of the open interest on natural gas futures contracts available on NYMEX during the winter months from 2006-2007.6 Since they controlled such a large proportion of these natural gas futures contracts, it was difficult for Amaranth to sell its energy portfolio and close off their losses as no institutions

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