Amaranth Advisors:

Burning Six Billion in Thirty Days

• Purpose of Case

• Deeper understanding of commodity futures in general and natural gas

markets in particular.
• Introduction to hedge funds and into the largest hedge fund collapse in
history
• Introduces the concept of liquidity risk, value-at-risk, spread trades and the
use of derivatives
Topics Covered in Case
• Hedge Fund industry
• Exchange traded futures contracts
• Natural gas markets and related trades
• Reconstructing of ‘reverse – engineering’ positions
• Liquidity risk
• Value-at-Risk
• Management of an investment fund
• Alpha v/s Beta
Pre-Requisites
• Knowledge of hedge fund industry
• Types of hedge funds and strategies employed by hedge funds.
• What hedge funds are and how they differ from mutual funds
• Comparison to mutual funds
• Difference between alpha and beta
• Beta is measure of market risk, whereas alpha is measure of risk-adjusted performance.
(firms seeks to minimize beta and maximize alpha through balancing long and short
positions)
• Does the incentive structure of hedge funds cause managers to take on highly
risky positions?
• Is it fair to that such a high fee is charged
• Is the fee justified because the industry attract some of the top professionals in the country?
• With rapid growth of hedge funds, it is becoming harder to find attractive
investment opportunities in the market?
• Should the industry be regulated?
Newspaper release on September 22, 2006
• The fund was down 65% during the month of September
• The fund was down 55% year-to-date
• The fund lost $560 million on September 14

• End of August $9.2 billion of assets under management

• Reported 27% profit between January to August 2006
• (implies that fund started the year with $7.2 billion assets – assuming no
withdrawals or additional investment)
DAAS’s Investment in Amaranth
various gain/loss figures for DAAS’s investment in Amaranth. These figures are
representative of gains or losses investors in Amaranth would have realized
Amaranth Implied Case Fact
DAAS
Investment
Dec. 2005 value – base $ 7.2 Billion $ 80 Million $ 80 Million
Aug. 2006 value – up 27% from beginning of year $9.2 Billion $ 102 Million >$100 Million
Sept.20, 2006 value – down 65% from August High $3.2 Billion $ 36 Million Not Available
Losses Dec.2005 – Sept. 20, 2006 $4.0 Billion $ 44 million $44 Million - $50 Million
Losses Sept. 1 – 20, 2006 $6.0 Billion $ 66 Million Not Available
Amount returned to investors by Dec.2006 $1.6 Billion $ 18 Million $ 18 Million
Amount still expcted to be returned to customers $1.0 Billion - $11 Million - $ 12 Million - $ 15
$ 1.6 billion $ 18 Million Million
• News releases also suggested
• Amaranth paid $250 million to Merrill Lynch over the September 16/17 weekend to
assume a small portion of their natural gas positions.
• Amaranth (reportedly) paid $2.15 billion to JP Morgan and Citadel after the markets
closed on Tuesday, Sept.19, to offload the majority of their remaining natural gas
positions.
• Total amount of $2.4 billion paid to eliminate the fund’s natural gas exposure is
assumed to represent a cost in addition to mark-to-market losses of the portfolio at
the time of transaction.
• The losses amaranth incurred from Sept 1 – 19 due to market movements in natural
gas prices are estimated at $3.6 billion.
• A wall street news release also claimed that Amaranth lost $800 million between
September 18 and September 19 and over $2 billion from September 1 to September
15.
• Exhibit 6 – in case, the loss breakdown was presented
Losses Breakdown

Factor Estimated Loss

Sept. 1-15 - Losses 1 $2.5 billion to 2.8 billion
Sept. 18-19 - Losses $0.8 billion to 1.1 billion
Partial Sale of Energy Portfolio - Merrill Lynch $250 million
Sale of Remaining Energy Portfolio to JPM & Citadel $2.15 billion
Total Losses (Sept. 1-20) ~$6.0 billion

1Included losses of $560 million on September 14

Trades
• The losses Amaranth incurred in September 2006 were primarily due
to natural gas bets the und had made.

• Three natural gas trades which Amaranth made

• Long winter – summer spread
• Long March – April Spread
• Long winter contracts

• Each of these three positions is plausible – as Amaranth experienced

significant declines during the period of Sept.1 - 19
Natural Gas Markets
• Natural gas markets are largely regional – unique in nature as other
markets are driven by global demand and supply whereas -
• Future prices on exchanges are primarily driven by aggregate demand and
supply factors in the US (gas not easily imported)

• Winter prices are higher than summer prices because of consumption

• Supply is also effected by hurricanes
• Exhibit 4 natural gas future prices curve
Entering Into Future Market
• At time of transaction
• Sample quoted price – 11 month future $10.00 mmBtu
• Units/ Contract 10,000 mmBtu
• Nominal value – one contract $100,000
• Margin Requirements $8,100
• Cash Required to Entered into one contract $8,100

• 10 days later:
• Sample quoted price – 11 month future $09.00 mmBtu
• Units/ Contract 10,000 mmBtu
• Nominal value – one contract $90,000
• Margin Requirements $8,100
• Losses to date ($10,000)
• Cash Required $18,100
• Margin requirements vary depending on the future contract. For simplicity/ illustrative purposes,
margin is assumed to be $8,100
Entering Into Spread Trade
• At time of transaction
• March 2008 futures prices $10.50 mmBtu
• April 2008 futures prices $9.10 mmBtu
• Spread (long March/Short April) $1.40 mmBtu
• Units/ Contract 10,000 mmBtu
• Nominal Value/Contract: March $105,000
• Nominal Value/Contract: April $91,000
• Nominal Value/ Contract – Spread $14,000
• 10 days later:
• March 2008 futures prices $9.80 mmBtu
• April 2008 futures prices $9.05 mmBtu
• Spread (long March/Short April) $0.75 mmBtu
• Units/ Contract 10,000 mmBtu
• Nominal Value/Contract: March $98,000
• Nominal Value/Contract: April $90,500
• Nominal Value/ Contract – Spread $7,500
• Loss/ Contract $6,500
Analysis of the Trades
• NYMEX restricts the positions of any firm to 12,000 contracts in a given month or a
net position of 12,000 contracts across all months. However larger positon may be
allowed by authorities in certain circumstances

• Size of the position relative to open interest – as NYMEX contracts are limited, the
higher the implied number of contracts relative to the open interest, the lower the
chances that Amaranth would have been able to build such a position.

• Implied losses for the Sept.1 – 15 period and the September 18-19 period. The
expected losses for these two periods are calculated based on the number of
contracts needed to generate a $560 million loss on September 14. If these
estimates correspond with the loss estimates discussed previously, the hypothesized
position is considered to be more likely.
Analysis of March-April Spread Trade
• Weighted avg. Sept. 13 spread (exhibit 7a) $2.1171
• Weighted avg. Sept. 14 spread (exhibit 7a) $1.9815
• Spread decline Sept. 14 $0.1356

• Contract Size 10,000

• Loss per contract, Sept. 14 10,000 *0.1356 = $1,356
• Sept. 14 Loss (given) 560,000,000

• Implied number of contracts = 560,000,000/1356 = 412,863 contracts

• This result means that amaranth must have had a total 412,863 spread
trades (total over 2007 – 2011 contract years) in order to incur a $560
million loss on Sept. 14

• These trades are equivalent to a long position in combination of 412,863

March 2007-2011 contracts and a short positon in the same number of
April 2007-2011 contracts.

• Such an implied position, however is more than 3 times the total open
interest of the March and April contracts over the years 2007 – 2011
(exhibit 7a)
• The following calculations reveals the losses that would have resulted
from these huge implied March-April trades over the September 1 –
19 , 2006 period.

• The corresponding losses are reported in the business press and

summarized in case Exhibit 6 are presented for comparison
Analysis of Implied Losses
• Sept. 1 – 15 spread decline $0.846
• Sept. 18 and 19 spread decline (from Sept. 15 level) $0.449
• Implied number of contracts 412,863

• Implied loss Sept. 1 – 15 (0.846 * 412,863) $3.493 Billion

• Estimated Losses Sept. 1 – 15 (case exhibit 6) $2.8 billion

• Implied Loss Sept. 18-19 $1.854 Billion

• Estimated Losses Sept.18, 19 (case Exhibit 6) $1.1. Billion
• We can calculate the implied losses for other trades also.

• In all the three cases the implied losses for September 1 -15 and September 18-
19 periods do not match the reported losses, although the winter summer spread
is close.

• It is highly unlikely that Amaranth held only the March-April spread trade, as this
would imply a huge position relative to open interest

• Similarly, the open interest that would be required if Amaranth just held the
winter summer trade represents about 81% of the average open interest of
summer and winter months out till 2011- another unlikely scenario.
• In terms of number of contracts, the long winter trade appears to be more realistic.

• The natural gas position of spread trades is zero, whereas the net position of the long
winter trade is 109,680 contracts.

• These are well above the 12000 limit set by NYMEX. NYMEX also sets a maximum limit of
12,000 contracts in any one month.

• Both the spreads would result in positions well above this limit.

• It is fair to say, though, that Amaranth did no have to build its position through NYMEX
only and it was rumoured that Amaranth had extensive over-the-counter bets (upto
100,000 contracts in single maturity. Hence position limits may not be as relevant.
• So, the conclusion is, that regardless of what position Amaranth had,
it was very large relative to the market. And Amaranth likely had a
combination of these positions, rather than just one.
Liquidity Risk
• $2.4billion out of Amaranth’s $6.0 billion in losses was from payments
made to counter parties to eliminate its natural gas exposure.

• It is assumed that the entire $2.4 billion was above and beyond
market losses experienced by Amaranth, and this assumption is in
line with information from newspaper articles.

• We need to answer, Why Amaranth would pay extra to get rid of its
position when it could have sold the positions in the market, and
raising the following key points:
Liquidity Risk
• It is clear that Amaranth had a huge position relative to the market. It would be very hard
for them to unwind or sell these positions in a short time frame.
• As Amaranth’s position declined, they would have faced margin calls and needed cash to
meet these requirements. Normally, one would be able to sell positions if faced with
margin calls, but because of its position size. Amaranth was not able to do this and was
forced to sell its position below market value.
• The $2.4 billion can be viewed as losses due to a lack of liquidity. If Amaranth had not
had cash pressures and had been able to hold on to its position, it might have been able
to prevent the $2.4 billion loss.
• The fact that JP Morgan had made $725 million shortly after assuming Amaranth’s
position provides evidence to support the argument that the $2.4 billion was a liquidity
loss. JP Morgan had the luxury of unwinding its position over a longer time frame.
• People who have large positions, which they cannot easily liquidity, are susceptible to
having other traders push prices against them, causing further losses.

• Lesson: Even though one have a paper gain, it is difficult to unwind a large position in a
short time frame without incurring significant losses relative to the market value.
Conclusion
• The positions were not truly hedges, but rather directional bets on the prices of
natural gas.
• One trader out of 420 employees was directly responsible for over 50% of a
fund’s assets
• Highly volatile returns over the last year indicate that there is a potential for large
losses.
• The amount invested in public equities/debt had declined from $7.1 billion on
March 31, 2006 to $5.7 billion by June 30, 2006; this may have been a sign that
the fund was putting more funds towards natural gas bets.
• Other sophisticated investors withdrew their investment (although this may not
have been publicly known at that time)
• Amaranth’s book should have been seen during the time they had their
investment; the potential liquidity risks amaranth faced would have been
recognized if their bets went the wrong way.
• VaR –
• Regulation
• John Arnold
• Traded against Amaranth
• Management of a hedge fund
• Control of Brain Hunter