FRM Final Report

8/8/2019 FRM Final Report

1/13

Amaranth

Advisors-Risk

Management

FRM Group Project

Prepared by:Balram Ramesh (09P013)Dhaval Dholabhai (09P016)Vipul Prakash (09P060)Rahul Kumar (09P106)Olga Sieben


2/13

2

Index

1. Background........................................................................................... ..........03

2. Capital.............................................................................................................03

3. Brian Hunter....................................................................................................03

4. Amaranth strategy...........................................................................................04

5. The Debacle.................................................... ................................................05

6. Natural gas futures Market..............................................................................06

7. Risk Management...........................................................................................07

8. September06 Volatility...................................................................................09

9. Macro Impact......................................... .........................................................1010. Lessons from the debacle...............................................................................11

11. Aftermath of the company.................................................................. .............12

12. References........................................................................ ..............................13


3/13

3

Amaranth Advisors Risk Management

1. Background

Amaranth Advisors LLC (Amaranth) was founded in September 2000 in Greenwich, Connecticut, by

Nicholas Maounis as a hedge fund. Before he began Amaranth, Maounis had experience in managing

a variety of arbitrage accounts in the US, Japan, Europe, and Canada. Initially, Amaranth used

conservative investment strategies like convertible arbitrage(simultaneous purchase of convertible

securities and the short sale of the same issuer's common stock). When several hedge funds started

using similar investment strategies, the resulting profitability came down. Maounis then shifted

Amaranth's focus to energy trading. By 20052006, Amaranth had generated over 80% of its profits

from energy trading. Although Amaranth had several funds, the principal fund, with $7.85 billion at the

end of August, 2006, was the Amaranth LLC fund. This fund was structured as a multi-strategy fund

that could invest in virtually any market without any position limitations. The various types of

strategies included energy arbitrage and other commodities, convertible bond arbitrage, merger

arbitrage, credit arbitrage, volatility arbitrage, long-short equity, and statistical arbitrage.

2. Capital

In terms of Amaranths capital, about 60% came from funds-of-funds, about 7% from insurance

companies, 6% from retirement and benefit programs, 6% from high net-worth individuals, 5% from

financial institutions, 2% from endowments, and 3% was insider capital. The insider capital was not

charged management or incentive fees. Amaranth commenced operations in 2000 with approximately

$200 million in capital, mainly provided by Paloma entities. The largest investor in Amaranth by 2006

amounted to 8% of total capital. Minimum investments in Amaranth were $5 million. The management

fee was 1.5% and the incentive fee was 20%.

3. Brian Hunters Background

Brain Hunter grew up near Calgary and earned a master's degree in mathematics from the University

of Alberta. Hunter gained experience at Calgary based TransCanada Corp. before moving to New

York to join Deutsche Bank in May 2001. There, he made $69 million for the bank in his first two

years. By 2003, Hunter was promoted to head of the bank's natural gas desk.


4/13

4

4. Amaranth Strategy

In April 2004, Amaranth, which was looking to expand its energy-trading business, hired Hunter.

Energy trading was just taking off again in the wake of Enron's bankruptcy, and guys who had a clue

were scarce. Hunter started generating good profits in energy trading. In 2005, Hunter made a huge

bet that natural gas would get more expensive. Hurricane Katrina struck, and it severely impacted

natural gas and oil production and refining capacity. Amaranth returned 21% in 2005, almost all of

which came from energy trades. Hunter made his fund more than $1 billion in 2005 and got his $100

million-plus payday. Maounis named Hunter co-head of the firm's energy desk and gave him control

of his own trades. Amaranth even quite unusually accommodated Hunters request to leave the New

York area and return to his home and native land by opening an office in Calgary for Mr. Hunter and

his team.

Exhibit: 1

In early 2006, Hunter used excessive leverage and invested in natural gas derivatives on NYMEX and

ICE. Hoping for a repeat performance, Hunter's analysis led him to believe that natural gas during the

winter of 2006-07 would be very expensive relative to the price in the summer and fall. To capitalize

on that, he employed trading strategies that involved going long natural gas that would be delivered

that winter, while shorting natural gas that would be delivered in the fall of 2006. He pursued thesestrategies to an extreme. Amaranth's trading positions in the natural gas market were taken through


5/13

5

Exhibit: 2

several types of derivative instruments like futures, spreads, options, and swaps. As of September

2006, it had investments in instruments with maturities ranging between October 2006 and October

2011. Amaranth's positions accounted for 60% to 70% of the open interest in futures contracts for the

following winter. Many traders were reluctant to take positions opposite Amaranth, regardless of their

view on market fundamentals, due to Amaranth's demonstrated ability to affect natural-gas prices

through large trades.

5. The Decline

However, in late August, his Katrina-sized bet went wrong and prices of natural gas contracts moved

in opposite direction to his estimates. The spread between the March and April futures contracts for

2007 was $2.49 during the last week of August. By Sept. 15, it fell to $1.15, more recently tumbling to

58 cents. Contracts for March-April bets in 2008 and 2009 - contracts that tend to be less volatile -also narrowed, wreaking havoc on the funds portfolio. That led to margin calls from Amaranth's

lenders. Its margin requirements - the amount of cash required to back its positions - skyrocketed,

hitting $3 billion by early September. Amaranth began selling positions at a loss to raise money. On

Sept. 20, J.P. Morgan , which had served as Amaranth's clearing firm, and Citadel took Amaranth's

positions in exchange for a $2.5 billion payment, which left investors with about a third of the money

Exhibit: 3


6/13

6

they'd once had. Amaranth eventually had to wind up with US$ 6.6 billion losses. On September 29,

2006, the founder of Amaranth sent a letter to fund investors notifying them of the fund's suspension,

and on October 1, 2006, Amaranth hired the Fortress Investment Group to help liquidate its assets.

6. The Natural Gas Futures Market

The natural gas futures market is a very unique Market. During the summer months when supply

exceeds demand, natural gas prices fall, and the excess supply is placed into underground storage

reservoirs. The futures curve for natural gas futures is quite unlike many other commodities. The

futures curve consists of a sine-like wave of altering contango and backwardation segments.

Traders in natural gas futures have several options. Firstly, the largest exchange for trading natural

gas futures is the NYMEX which has futures contracts for every delivery month up to five years out.

They also have options on all of the futures contracts, as well as spread options whose payoff isbased on the difference between the futures contract prices of two different months. The initial margin

requirement on futures contracts varies by type of trader (non-member customer, member customer

and clearing member and customer) and also varies by time to maturity of the contract. Contracts

closer to delivery have stricter margin requirements. The expiration of the contracts is usually a few

days before the end of the prior month and there are conventions for the last trading day of each

contract which can be obtained from the NYMEX.

In addition to NYMEX, traders can use the ICE, which is a virtually unregulated exchange but

performs very similar functions. ICE is the leading exchange for the trading of energy commodity

swaps in natural gas and electricity. Traders also can use the ICE trading screen to enter into OTC

transactions with other parties to buy or sell natural gas. One major difference between NYMEX and

ICE is that ICE has no legal obligation to monitor trading due to its status as an electronic trading

facility. In addition, the CFTC had no authority or obligation to monitor trading on ICE.


7/13

7

Exhibit: 4

7. Risk Management

In a conference call to investors, the CEO of Amaranth repeatedly mentioned that Amaranth had

experienced professionals monitoring the risk of the firms positions, as well as noting that the events

of September were unusual and unpredictable.

Amaranths Risk Policy:

Amaranth was slightly unique in terms of risk management in that it had a risk manager for each

trading book who would sit with the risk takers on the trading desk. This was believed to be more

effective at understanding and managing risk. The risk group produced daily VaR and stress reports

with VaR confidence levels of 68% and 99.99% over a 20-day period. The risk management team

also produced a liquidity report which would present positions and their volumes for each strategy. In

addition, Amaranth maintained a certain amount of risk capital to be used for anticipated margin calls

on its positions. For example, in May 2006, it had $3 billion or 30% of capital in cash for these

purposes. Amaranth used several prime brokers and excess borrowing facilities to fund its positions.

Amaranths risk exposure was examined with respect to the hypothesized positions. Two dimensions

of risk were analyzedliquidity risk and market risk. Market risk is the risk that occurs from the

volatility of investment returns, while liquidity risk measures the degree of difficulty in exiting a given

trading position.


8/13

8

Market Risk

In order to calculate market risk, a simple value-at-risk (VaR) measure as well as one that corrected

for skewness and kurtosis in returns; a Cornish-Fisher VaR is used. The analysis of VaR on August

31, 2006, could explain about 65% of Amaranths losses. That is, a simple VaR calculation by risk

managers at Amaranth would have indicated the potential in a worst case scenario (i.e., less than 1%

of the time) of losing 65% of their actual losses. Thus, Amaranths energy trades were, by

construction, very risky from a market risk point of view. However, this should not be confused with

carelessness, because the strategy of the fund may have been designed for very high risk.

Liquidity Risk

Liquidity is defined as the ability to sell a quantity of a security without adversely changing the price in

response to ones orders. One simple precautionary measure that practitioners use to control liquidity

risk is to measure the size of their trades versus the average daily trading volume of a security. A rule-of-thumb is to not hold positions greater than 1/101/3 of the average daily trading volume over some

specified time interval, such as the last 30 days of trading.

Exhibit: 5

Above figure shows various positions of Amaranth in natural gas futures on August 31, 2006 as

multiples of the trailing 30 day average daily trading volume on NYMEX in each contract. Even though

some of Amaranths positions were with ICE and not NYMEX, these positions were extremely large

relative to the average daily trading volume of the largest natural gas futures exchange (NYMEX) and

were even large with respect to the open interest. It was also found that contracts whose open

interest was much higher on August 31, 2006, than the historical normalized value experienced larger


9/13

9

negative returns. In particular, every 10 units more open interest than the normalized average led to

an extra decline of 2.6% for that particular futures contract. Given that Amaranth was the main source

of this extra open interest in certain contracts, the events of September were adverse from a liquidity

perspective as well.

8. September06 Volatility

Historically, a spread trade in natural gas futures had done quite well. The Exhibit 6 below shows the

average returns of different maturity futures contracts in the month of September from 19902005.

One can see that generally, winter month returns are higher than non-winter month returns and that

natural gas prices have tended to rise on average in September for the first 36 months out. Some of

the near contracts had returns as high as 5.73% on average in September. In September of 2006, the

natural gas futures market behaved entirely differently than it had historically. Exhibit 7 shows the

behavior of natural gas futures returns in September of 2006. The x-axis plots the contract months

forward. Thus, in this particular exhibit, 1 represents the returns for the October 2006 futures contractduring September, 2 represents the returns for the November 2006 contract in September, and so on.

One can see from this exhibit the dramatic negative returns of natural gas futures in September,

which was as low as 27% for front-month contracts. One can also see that the negative returns were

less for non-winter months. That is, although returns were severely negative for most natural gas

futures contracts, they were worst for winter months, all the way across the maturity spectrum. For

example, for the first year out, the contract months 26 did poorly, representing the contracts for

November 2006March 2007, while in months 713, the negative returns were less severe

representing the months April 2007October 2007. This pattern is seen for futures contracts in future

years as well. This pattern would not bode well for a strategy that was long winter and short non-

winter months. During the period from August 31, 2006 to September 21, 2006, Amaranths actual


10/13

10

Exhibit: 6

natural gas futures position may have changed for a variety of reasons. However, if we assume its

positions during September were quite close to the positions on August 31, 2006, then the changes in

natural gas futures in September would have led Amaranth to lose $3,295,239,642. Their actual total

loss over this period was $4,350,600,000. Part of the discrepancy could be due to not having access

to all of Amaranths positions, some could be due to losses in other parts of the Amaranth portfolio,

and some of it may be due to Amaranth changing their positions during the period. Eventually, margin

calls on the large losses led Amaranth to search for buyers of its portfolio and the liquidation of the

fund.

Exhibit: 7

9. Macro impact of the debacle

The collapse of the $9.668 billion Amaranth hedge fund in September of 2006 due to bets on natural

gas attracted widespread media attention. It raised concerns among many investors as to Amaranths

actions in terms of managing the fund which led to major losses. Furthermore, it added to the debate


11/13

11

among regulators and authorities that the speculative activities of hedge funds may be riskier than

they appear to be.

On the surface, the Amaranth collapse did not significantly impact broader markets. In fact, there are

many positives in that the daily margin collection of the NYMEX worked to prevent a larger crisis.

However, when security prices are diverted from their fair values due to bubbles or market

manipulation by large players, consumers of these products ultimately bear the burden of an unfair

distribution of income. In the natural gas markets, some of these consumers include residents,

schools, hospitals, small businesses, local electricity plants, and others.

Regulators might ask if transparency would have aided investors in understanding the extent of

Amaranths exposure to energy. Risk managers and regulators alike might also ask for standardized

measures of liquidity risk, since liquidity risk seemed to be excessively high perhaps without any

obvious signal to risk managers at Amaranth. Finally, a supervisory board like the CFTC might be

required to have an oversight committee that has access to positions across exchanges on similarproducts for a more thorough liquidity analysis. In fact, on September 17, 2007, Senator Carl Levin of

Michigan introduced a bill to regulate electronic energy trading facilities by registering with the CFTC

(Levin [2007]). The bill also proposes to provide trading limits for energy traders that can be monitored

by the CFTC across all energy trading platforms and exchanges, requires that large domestic traders

of energy report their trades on foreign exchanges, and defines precisely what constitutes an energy

trading facility and an energy commodity.

10. Learning from the case

(1) Poor Position Sizing: Amaranth's Risk Management team was obviously napping or naive. They

were running a `diversified' fund which had, at the end of August, about $3 billion (30 per cent of the

fund) invested in natural gas futures, a highly volatile commodity.

Historically, the spread in future prices for the March and April contracts have not been easily

predictable. The spread is dependent on meteorological and sociopolitical eventswhose uncertainty

makes the placing of such large bets a precarious matter. So, absolute position limits on Mr Hunter's

positions should have kicked in long ago. The Risk Management unit of the hedge fund should have

also tracked and spotted the tightening spreads between the March and April 2007 contracts a lot

earlier. This would have helped to reverse positions and stop losses before it became a crisis

(2) Poor Risk Management: A VaR (Value-at-Risk) analysis would have given an indication of the size

of possible losses, given the high volatility of the underlying commodity (natural gas). Under no

circumstance should this VaR cross more than 5-10 per cent of the corpus of the fund. Here, it

crossed 35-40 per cent of the fund. Technology can be harnessed to process the large amounts of

historical data that need to be analysed to track trends and arrive at accurate VaR figures.


12/13

12

(3) Ignoring the (il)liquidity risk: The numbers also suggest that Amaranth held a significant portion of

the gas futures market, which has less liquidity compared to the oil futures market. Unwinding large

positions in an illiquid market compounds the problem. When Amaranth got margin calls caused by

losing positions, they had to sell their open positions in the market. Very soon, the market got wind of

what was happening and took advantage of Amaranth's desperate situation by offering poor prices.

The high amount of debt that Amaranth carried relative to owned funds (gearing) further exacerbated

the problem. As a result, Amaranth incurred further losses of about $3 billion simply trying to unwind

its positions. So risk managers need to track positions not only with relation to the total funds

deployed, but also with relation to the size of the market.

Lastly, investors in hedge funds need to be aware of the risks that they are getting into. They need to

track the exposure of the fund to various sectors. At the end of the day, it is their money on the line. In

the case of Amaranth, its investors, many of them sophisticated in terms of market knowledge, did not

do this.

11.Aftermath of the company:

In the end, most investors in the Amaranth Fund were left scratching their heads and wondering what

happened to their money. One of the biggest issues with hedge funds is the lack of transparency for

investors. From day to day, investors have no idea what the fund is doing with their money. In reality,

the hedge fund has free rein over its investors' money.

Most hedge funds make their money with performance fees that are generated when the fund

achieves large gains; the bigger the gains, the bigger the fees for the hedge fund. If the fund stays flat

or falls 70%, the performance fee is exactly the same: zero. This type of fee structure can be part of

what forces hedge fund traders to implement exceedingly risky strategies.

In September of 2006, Reuters reported that Amaranth was selling its energy portfolio to Citadel

Investment Group and JP Morgan Chase. Due to margin calls and liquidity issues Maounis pointed

out that Amaranth did not have an alternative option to selling their energy holdings. Amaranth later

confirmed that Brian Hunter had left the company, but this is small comfort for investors who had large

investments in Amaranth.

Investors will likely be able to liquidate what is left of their original investment after the transaction to

sell the assets is complete, but the final chapter to this story has yet to be written. However, the storydoes serve to illustrate the risk involved with making large investments in a hedge fund, regardless of

the fund's past success.


13/13

13

12. References:

1. The Amaranth Debacle:A Failure of Risk Measures or a Failure of Risk

Management?- LUDWIG B. CHINCARINI

2. spidi2.iimb.ernet.in/~networth/EconomicDigests/Amarnath.pd

3. www.worldscibooks.com/etextbook/7141/7141_toc.p

4. en.wikipedia.org/wiki/Amaranth_Advisors

5. ww.toomre.com/AmaranthVows

Documents

FRM Final Report