Scribd
Upload
5 views

Derivatives

Amaranth Advisors placed an excessive amount of risk on a single natural gas position, representing over 50% of its portfolio. While Hunter's strategy was based on past probabilities, such concentration of risk in a single position made Amaranth vulnerable when market conditions changed. Amaranth's high leverage of 8:1 meant it had little ability to withstand losses. Weak risk management allowed excessive exposure and lack of scenario planning prevented consideration of how the position could be affected by changes in supply and demand.

Uploaded by

kkstarrr2
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
5 views

Derivatives

Amaranth Advisors placed an excessive amount of risk on a single natural gas position, representing over 50% of its portfolio. While Hunter's strategy was based on past probabilities, such concentration of risk in a single position made Amaranth vulnerable when market conditions changed. Amaranth's high leverage of 8:1 meant it had little ability to withstand losses. Weak risk management allowed excessive exposure and lack of scenario planning prevented consideration of how the position could be affected by changes in supply and demand.

Uploaded by

kkstarrr2
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 2

They failed to diversify effectively and placed an excessive amount of risk on a single subject.

It was
clearly inflated, because this individual trade represented more than 50% of the portfolio.

Although positions based on past probability around natural gas price changes, might potentially be
sustained by the calendar spread that Hunter utilized, such an approach is more likely to be successful, if
it fits specific requirements. A management must evaluate whether the historical probability and payoffs
are favorable for a certain approach while acknowledging that he or she has imperfect vision into the
future. The transaction must be handled about the same as any other trade in order for the law of
averages to have a chance of succeeding, and the position must fall within the parameters of the
mandate of a specific portfolio. Hunter may today be well-known for the amount of money he made on
this call if it had succeeded. An investor or trader needs to stop concentrating on a single expected
outcome and start considering alternative outcomes or scenarios.

Amaranth had a weak foundation for the positions it took, and to make matters worse, the business
made sure it was unable to leave those positions on time. Amaranth effectively "became" the market for
these contracts by controlling substantial amounts of individual natural gas contracts (in some
categories, Amaranth held more than 50% of a given contract). In reality, such a position meant that
Amaranth would be unable to unwind its bets if the transactions failed for any reason. Liquidity is
necessary to exit any position, but it is particularly crucial during turbulent situations when not only do
securities' prices perform poorly, but also their trading liquidity deteriorates significantly, making it hard
to trade the contracts. Given that Amaranth controlled more than 50% of these troublesome contracts,
when Hunter's position became negative, liquidity dried up, making it nearly impossible for Amaranth to
earn a profit at any cost. Other hedge funds reversed similar transactions after noticing Amaranth's
plight, worsening the issue. When evaluating the dangers of stress-related departure plans, liquidity
must be considered, that is as a potential opportunity should the investor be able to sustain the crisis if
liquidity is wrongly quoted.

The Energy Hedge Fund Centre's (which monitors 525 energy hedge funds) co-principal Peter Fusaro
says: "The key to the ruin of Amaranth is the level of the fund’s leverage. Their leverage was about 8:1
so $7 was borrowed for every $1 the fund had from its clients. Positions were on exchanges and over
the counter and were thus very vulnerable." Additionally, Russel Corn, managing director of Diligence, a
corporate intelligence agency said that “There is no reason to believe that his information was not
correct, but what ruined Amaranth was that the risk management team should not have allowed it such
heavy exposure.”

Learning

One of the key pillars here is that correlation is not causation. As a result, for the law of averages to
apply, transactions based on observable correlations must be substantially diversified. This means that
correlation trades are only a valid type of trading if the investor admits that they are unaware of the
explanations why the patterns may continue, return to the mean, etc. As a result, the investor in
correlation trades needs to spread risk across numerous different risk exposures and employ small
position sizes. Contrarily, trades based on a favorable upside-to-downside ratio or a grasp of cause and
effect may be made with more assurance.
Hunter made the wager under the influence of status quo bias, which is the widespread assumption that
current market behavior will continue into the future. Perhaps Amaranth's huge profits from natural gas
contracts the year before, motivated an eager desire to raise that success. With regard to the price of
natural gas, Hunter did not comprehend the distinction between correlation and causality.

Recommendations

By conducting simple scenario planning to assess at what would happen after various changes in the
underlying supply and demand for natural gas under mild, moderate, and severe weather scenarios,
Amaranth Advisors could have prevented all of this trouble. The company should have done at the very
least a what-if study for negative changes in market values.

We haven't seen any clear evidence to back up regulators' claims that Amaranth and Hunter intended to
influence natural gas market pricing, but this is a possibility. Amaranth may have been able to avoid this
situation if Hunter hadn't been hired in the first place. The character of the individuals they recruit can
be better understood by human resource departments. Of course, the firm's targeted trading strategy
might have included the recruitment Hunter.

You might also like