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The Collapse of Amaranth Advisors

The Collapse of Amaranth Advisors. By: Shannon Woolley. Amaranth Advisors. Private hedge fund founded by Nicholas Maounis in 2000 Amaranth = “never-fading” Headquarters: Greenwich, CT Houston, London, Singapore, Toronto Employed 115 traders, portfolio managers, and analysts

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The Collapse of Amaranth Advisors

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  1. The Collapse of Amaranth Advisors By: Shannon Woolley

  2. Amaranth Advisors • Private hedge fund founded by Nicholas Maounis in 2000 • Amaranth = “never-fading” • Headquarters: Greenwich, CT • Houston, London, Singapore, Toronto • Employed 115 traders, portfolio managers, and analysts • Multi-strategy = freedom • Primary profit center: Convertible Arbitrage • Capital flow into this strategy increased  hard to find trading opportunities

  3. Energy Trading • To avoid bear market, hedge funds bought “alternative assets” such as commodities, specifically energy • 2004-2006: ¼ of hedge funds' assets  commodities and energy • Increased buying raised prices of oil and gas • Higher prices, higher risk • 2004-2005: Maounis shifted focus to energy trading • Hired energy trader: Brian Hunter • Later blamed for firm’s collapse • Multi-strategy? • Energy desk posted around 30% of annual returns

  4. Brian Hunter • Canadian trader, hired at age 32 • Placed “spread trades” in natural gas market • Within 6 months, Hunter made Amaranth $200 million • Impressed bosses • 2005: Generated profits of $1 billion • Bullish bets on natural gas prices • Made $75 to $100 million for himself • Placed him among the 30 highest paid traders in Trader Magazine International Man of Mystery, Hunter wouldn’t let anyone take his picture

  5. Spread Trading • Trader simultaneously buys (longs) and sells (shorts) options or futures contracts for two related commodities or securities • Profit comes from the difference, or “spread” between the two prices • Prices of different contracts will often change differently over time • Spread positions are usually more stable than taking an outright position • Commodities are notoriously unstable, so Amaranth thought they reduced risk by taking spread positions in natural gas

  6. Futures Spread Trading Example • Today’s date: July 31, 2006 • Contracts – each worth 10,000 MBTU of natural gas • March 2007 – Long (buy) • April 2007 – Short (sell) • Closing Prices on July 31,2006: • March - $11.461 • April - $8.851 • Notional Values (Price x 10,000): • March - $114,610 • April - $88,510

  7. Futures Spread Trading Example • Position is “hedged” in a sense • Natural gas futures prices can rise or fall • One position’s loss will be partially offset by other’s gain • Ideally the prices for: • March – decrease, buy at cheaper price • April – increase, sell for higher price • Position focusing on “spread bet” • March futures contracts will have higher return than April futures contracts • August 2006 – this was the case

  8. Futures Spread Trading Example • By August 31, 2006 the contract prices were: • March 2007 - $10.843 • April 2007 - $8.343 • Say we close out the position on August 31, 2006

  9. Futures Spread Trading Example • Initial Capital Outlay: • $7,425 - Each contract • $14,850 - Total • To find the return: Profit = $4,700 = 31.6% Initial Cost $14,850 • Even though prices dropped, spread profited

  10. Spread Trade with Options Example • Same data, but now we’re purchasing: • CALL on March 2007 futures • PUT on April 2007 futures • March 2007 contract: • Closing price- $11.461 • Strike - $11.50 • Call price - $2.429 • April 2007 contract: • Closing price- $8.851 • Strike - $8.75 • Put price - $0.525

  11. Spread Trade with Options Example • Original prices: • March 2007 Call - $2.429 • April 2007 Put - $0.525 • To make true spread, we must scale the contracts so we have equal investments in both • Ex: Buy 1 Call option and 5 Put options • New prices: • March 2007 Call - $2.429 • Notional value - $24,290 • April 2007 Put - $2.625 • Notional value - $26,250

  12. Spread Trade with Options Example • Initial Capital Outlay: • March 2007 - $24,290 • April 2007 - $26,250 • Total cost - $50,540 • Calculate our return: Profit = $37,190 = 73.6% Initial Cost $50,540

  13. Natural Gas Market • Exceptionally volatile • 5 times more volatile than stock market • Swings are more severe than oil • Gas cannot be stored easily • Spread depends on meteorological and sociopolitical events • Their uncertainty make it hard to predict futures prices • Historically, March and April contracts have been very difficult • 2005: Hurricane Katrina hits • Severely impacted natural gas and oil production – prices increase • Hunter makes enormous profits from his bullish bets

  14. Hunter’s Mistake • Amaranth’s energy investments started out conservative • Hunter’s bold bets and deep understanding of natural gas market led him and Amaranth to quick success • Success allowed him more freedom to make riskier moves • He bought options that others in the market thought unlikely • Riskier, but would provide big payoffs • Hoping for repeat performance of 2005, Hunter bet that the spread on that “shoulder month” would increase • Price of March 2007 contract would increase relative to April 2007 contract • Usually prices rise in winter and begin to fall off in spring months

  15. Downfall • Early September , prices fell suddenly due to oversupply • Hunter’s bets would payoff if prices rebounded, either on prospect of cold winter or nasty hurricane • 2nd week of September - proceeded to drop another 20% • Widely predicted hurricanes never came  prices of contracts collapsed • Prices went from $2.49 at the end of August 2006 to $0.58 at the end of September 2006 • Resulting in huge loss - $6.5 billion! • Losses exceeding 65%

  16. Aftermath • Sept. 20, 2006: Reported that Amaranth would transfer energy portfolio to 3rd party • Revealed to be Citadel Investment Group and JP Morgan Chase • Sept. 29, 2006: Maounis sent letter to fund investors • Notified them of fund’s suspension • Oct. 1, 2006: Hired Fortress Investment Group liquidate assets • July 2007: Amaranth and Hunter were charged with: • Attempted Manipulation of the Price of Natural Gas Futures (CFTC) • Market manipulation (FERC) • January 2010: FERC judge ruled that Brian Hunter violated their Anti-Manipulation Rule • 1st time FERC has found market manipulation by a futures trader

  17. Overlooked Risks • Increased media attention on risk management practices • ICE – leading exchange for trading energy commodity swaps in natural gas and electricity • Virtually unregulated exchange • “Risk of Ruin” – past the point of no return • Anything can happen in the short term • Not enough emphasis on: • Liquidity risk • Risk of Leverage • Market Risk

  18. Liquidity Risk • Risk that arises from difficulty of selling an asset • Investment may need to be sold quickly • Insufficient 2nd market may prevent the liquidation of the asset • Highly liquid = low liquidity risk • Example: Stock of publically traded company • Highly illiquid = high liquidity risk • Example: House • Amaranth’s liquidity risk was excessively high • Held extremely large positions relative to average • Hunter sometimes held 100,000 positions in a single contract

  19. Risk of Leverage How much bet was made on borrowed money? • Multiply gains or losses by borrowing money • Trader pays fraction of contract’s value – a margin • Commodities trades require less margin money upfront • 10% versus 50% in stock market • Amaranth could borrow 3 - 8 times their initial capital • Hunter had $3 billion of bets outstanding • Around 50% in natural gas of the fund • Most won’t risk more than 2% in any one sector • Borrowed $8 for every $1 of Amaranth’s funds

  20. Leverage Example Natural gas is $6 per MBTU Trader enters contract to buy/sell 10,000 MBTUs Value of Contract: $60,000 Margin requirement: 10% To make bet, trader only has to pay: $6,000 Say, price of gas goes down 10% Trader loses $6,000 At $0  must post another $6,000 margin Now, trader has $12,000 tied up in market Position value dropped to $54,000

  21. Market Risk • Risk that the value of an investment will decrease due to moves in market factors • Asset allocation and diversification can help protect against market risk • Different portions of the market tend to underperform at different times • Amaranth’s market risk was high • Energy desk posted around 30% of annual returns • Reasonable due to success?

  22. Hedge Funds: Increasingly Powerful Forces • 1990: Managed $38.9 billion in assets • 2006: 9,000 hedge funds - $1.2 trillion in assets • Improve efficiency of financial market by introducing: • Competition • New ideas • Liquidity • Amaranth’s collapse strengthens skeptics: • Increasingly high risks - can easily go awry • History is too short to reveal true risks • Should they be government regulated?

  23. Lessons • People can be wrong • “What Brian is really, really good at is taking controlled and measured risk” Nicholas Maounis • Market is unpredictable • Brian Hunter blamed the collapse on “an unprecedented and unforeseeable run-up in gas prices” • Every time you think you know what these markets can do, something else happens • No easy path to higher returns!

  24. Works Cited http://www.post-gazette.com/pg/06263/723449-28.stm http://www.nytimes.com/2006/09/19/business/19hedge.html?_r=1&oref=slogin http://www.thefirstpost.co.uk/2567,news-comment,news-politics,-hedge-fund-a-gamble-too-far http://finance.yahoo.com/expert/article/futureinvest/10116 http://www.nytimes.com/2007/02/09/business/09insider.html?_r=1&oref=slogin http://en.wikipedia.org/wiki/Amaranth_Advisors Chincarini, Ludwig B., Natural Gas Futures and Spread Position Risk: Lessons from the Collapse of Amaranth Advisors L.L.C. (January 19, 2008). Journal of Applied Finance, Spring/Summer 2008. Available at SSRN: http://ssrn.com/abstract=1086865 http://www.investopedia.com/articles/07/amaranth.asp

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