Amaranth Advisor was an American based investment advisory company, which managed approximately 9 billion in assets before it collapsed in 2006. The company was founded by Nicolas Maounis in Greenwich, Connecticut. Amaranth Advisor focused on managing multi-strategy hedge funds for its clients. The main strategy it utilized throughout its history was convertible arbitrage strategy. Meaning, the firm always took long positions on convertible securities and simultaneously took short positions on the same company's common stocks in order to seek arbitrage opportunities. However, during the early 2000s there were a lot of hedge fund firms that entered into convertible arbitrage market. It became difficult to find arbitrage opportunities in the convertible securities market. So Amaranth Advisor decided to shift its emphasis to energy market in order to keep their position in profitability and share benefit from the booming energy market. (Amaranth Advisor)
In September 2006, Amaranth claimed that it lost $6.6 billion on natural gas futures and accordingly declared its collapse. Brian Hunter, a Canadian trader who has a master degree in mathematics from the University of Alberta, is blamed for the collapse. Before he came to Amaranth, he had experience in the Deutsche Bank. While working at Deutsche Bank, Brian Hunter made $69 million for the bank in his first two years. Therefore, he was promoted to head of the bank's natural gas desk by 2003. However, in December 2003 Brian Hunter's trading team lost $51 million in a single week in one trade. He refused to allege the responsibility for the loss and insist that he should be paid a bonus by the Deutsche Bank for the $40 million profit he made for the bank during 2003. The Deutsche Bank refused his request and finally let him go. Nicholas Maounis agreed with Brian Hunter's trading strategy so he decided to hire Brian Hunter and name him the co-head of the firm's energy desk and allowed him to trade his stakes.
In 2006, Brian Hunter predicted that the gas prices for 2006-2007 winter would increase relative to the summer and fall gas prices. Therefore, hunter went long on the winter contracts and simultaneously went short the near summer and fall contracts. Unfortunately, the market went exactly against his prediction, so the company had to pay a huge amount of money to maintain the margin account. Once, the margin requirements even went above $3 billion. The company was not able to maintain the margin account anymore, so it decided to offload some of its positions, but this didn't solve the problem. Ultimately, it sold its positions entirely to JP Morgan and Citadel for $2.5 billion. The fund turned out to have a total loss of 6.6 billion U.S. dollar and had to be dissolved entirely. (Hunter).
Why this happened?
There were many reasons that lead to the company's collapse and large loss. It was definitely not smart for traders to risk more than 2% of their total account in one sector or instrument. However, Brian Hunter thought so. He used around 50% of the funds to invest in single natural gas market, which contained about 3 billion dollars, compared to its total funds of about 6.6 billion dollars that was invested in the energy markets. Hunter believed in himself and didn't consider the fact that he might be wrong. Hunter didn't use stops or have set points where he would know that he was wrong and he should exit. Therefore, his confidence was one of the reasons that caused the company's collapse (McCall).
Hunter repeatedly used borrowed money for his bets. He held bets believing that increasing demand for the contracts would increase the price. Therefore, Hunter purchased large amounts of the same contracts that his fund already owned. However, he ignored one important thing, that is, he did not consider if Amaranth and its lenders were willing to buy the contracts. It turned out that not many people wanted to purchase more contracts using their cash at hand, and this is another reason for the company's collapse. (Sender)
Amaranth's system to measure risk was too old to correctly measure how much risk the company would face and could not tell how to limit losses effectively. The models used historic data, but as the natural gas markets became more volatile this year, the company's system was less useful in managing the risk of investments in the natural gas markets. However, Hunter still used this old system. The old system could not be counted on as a reliable measure of risk and is an additional reason that helped lead to the company's collapse (Sender).
In addition to the outdated risk management system, Hunter's large quantities of bets were the major reason for the company's downfall. Hunter sometimes made bad bets. For example, he misjudged the movement of prices for different months. He estimated that the price of natural gas would increase in April after heavy use of natural gas in the winter. But the result was actually the opposite and the price decreased because the demand of natural gas in winter was less than expected and there was still plenty of gas available.
All the reasons mentioned above contributed to Amaranth's collapse together. It was a total matter of risk management controls.
Who was responsible?
According to what has happened and why it was happened, we believe that Brian Hunter was responsible and should be blamed for the company's loss. As the chief trader of natural gas for the company, Hunter made most decisions to increase investments in the natural gas markets.
Hunter believed in his analysis and calculations. He believed that the prices of natural gas would change in the direction that he estimated. Therefore, he purchased large quantities of options. For example, if he predicted that the price would increase a lot at a specific time in the future, he would purchase a large number of call options. Similarly, if he expected that the price would decrease a lot, he would decide to purchase many put options. However, things didn't go as what he expected. The prices turned out to be opposite to what he thought. So Hunter was unable to exercise his options. Furthermore, what he did declined the liquidity of the company, which meant the company was less able to deal with the emergency.
In early September, the price of natural gas fell unexpectedly because there were large amounts of storage being bought by consumers. He expected the price of natural gas to rebound either on a cold winter or a large hurricane, which would destroy the natural gas facilities. But finally the evidence indicated a small hurricane and warm winter, so the price of natural gas fell more. The company therefore took another major loss in the natural gas futures market. Furthermore, Hunter used the old risk management system as mentioned above.
However, considering all the things he did, we think the biggest mistake he made on this investment was that he extremely believed in himself and he held a lot of bets and depended on those bets. Such as when he bet that the winter would be cold and that a nasty hurricane would come. In reality, it turned out to be a small hurricane and a warm winter. So when Hunter purchased a lot of options and paid large premiums and the price turned out to move in the opposite direction than he estimated, because the he was wrong about the type of winter that was going to occur, Hunter lost billions of dollars. Consequently, Hunter is the most important person who was responsible for Amaranth Advisors' large loss in natural gas future contracts.
The Ripple Effect on the Market and Economy:
Amaranth Advisors lost approximately $6 billion on natural gas futures in 2006. This lost did not have a large impact on the economy as a whole though it did have a major shock to the market of hedge funds. Among other markets in the economy the energy market saw the biggest ripple effect after the Amaranth and Brian Hunter collapse. This was due to Brian Hunters manipulation of natural gas future prices. Though hedge fund s saw the biggest change in operations overall.
Hedge Fund Investor
The biggest lost from the Amaranth Advisors and Brian Hunter natural gas scandal was carried by the investors. Hedge fund investors do not always know what is happening with their money on a day to day basis. The hedge fund makes the decisions for the investor as to where their money will be invested and how much risk will be taken. This was a major problem when investors found out that Amaranth Advisors had lost close to 65% of their funds. The investors had no idea how risky the hedge fund was being and were shocked to learn that no securities were in place to prevent such a large lost.
As a result of the Amaranth Advisors lost in 2006, investors will no longer take large risk in hedge funds without first calculating their own risk. Investors have started extensively analyzing their trading practices and risk management options before entering into a hedge fund. Furthermore, investors no longer go on past performance of the hedge fund because it is now very well know that a hedge fund could do well for several years before making one high risk investment that could cause the fund to lose everything.
In addition to investors taking a more hand on approach when it comes to hedge funds, the SEC and the Federal Reserve have also become involved in the process of hedge funds and managing the risk being taken. This is because the money that is being invested is not the hedge funds money; it is the investors' money. Meaning that hedge fund managers, such as Brian hunter, will make more risk investments considering they have nothing to lose and the investors take all the risk.
Amaranth Advisors and Brian Hunter
Amaranth Advisors did not continue to operate after Brian Hunter lost over 65% of the company's assets. The company was charged with attempted manipulation of the natural gas futures in 2007 by the commodity commission. In 2010 the Federal Energy Regulatory Commission judge ruled that Brian Hunter violated the Commission's Anti-Manipulation Rule (Amaranth Advisors).
Risk Management Errors:
The Management
Amaranth Advisors was made of several seasoned professionals. Mr. Brian Hunter was related to the gas futures disaster. Hunter joined Amaranth in 2004, and was a former Enron trader. He created Amaranth's energy trading desk. Hunter had to report to Arora who was his supervisor; but he didn't want to report to Arora and therefore threatened to leave the company in 2005. Hunter also complained about the compensation structure. Maounis the director of the company allowed Hunter to trade separately from Arora, "this led to an increase in his operating profits from 7.5 to 15% and he helped Amaranth make $1 billion in profits in 2005" says Chincarini the author of Risk Management article. He was also allowed to return to Calgary his hometown to trade there. In the end his other natural gas traders had to migrate from Greenwich to Calgary. Since there were no solid rules for Amaranth employers to follow, they ended up setting their own terms of working which is not a good form of management.
The Strategies and Fund Structure
When Amaranth was created, it was more of a multi-hedge fund, however by 2006 they had most of the firm concentrated in energy portfolios. The multi-strategy portfolios included trades in Energy Arbitrage, Convertible Bond Arbitrage, Merger Arbitrage, Credit Arbitrage, Volatility Arbitrage, Long/Short Equity and Statistical Arbitrage. Their contact with these various strategies changed dramatically over the year. For example, "when Amaranth was created, 60% was allocated to Convertible arbitrage and at the end of 2006 only 2% was allocated to this strategy" says Chincarini author of management risks. Amaranth didn't have no stop limit and no concentration limits, which allowed the firm to focus more towards energy trading by the end of August 2006. There were no leverage restrictions with the firm. According to the article written by Chincarini, Amaranth's capital came from a variety of investors;
60% came from funds-of-funds
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% from insider capital.
Minimum investments in Amaranth were $5million, with a management fee of 1.5% and an incentive fee of 20%, employing a high water mark. There were no lending terms provided by Amaranth, therefore investors were allowed or would withdraw their investments whenever they felt like. This would leave the firm with fewer funds to carry out their trading.
Risk Management and Liquidity Management
"Amaranth was extraordinary in terms of risk management that it had a risk manager for each trading book that would sit with the risk takers on the trading desk," says Chincarini author of Risk Management. Therefore, there were reports created for each trading position in the firm. They thought this would to be a better way of understanding managing risk of the firm, therefore stressing each strategy separately. They hoped to come up with a better way of reporting that would include the entire firm's position in general. But I guess this didn't happen by the time the company collapsed.
Was it Preventable?
When a financial institution is managing portfolios for other companies, its goal is to make as much profit as possible for their clients. The only way a company can receive a large reward when trading funds is taking on a portfolio with great risks. The greater the risk is the greater the return will be. However, how much risk is too much risk? When the collapse of Amaranth Advisors occurred did take on too much risk? Was it preventable? Brian Hunter was known to be very upfront when it came to trading future contracts, he was known to be a person to take on a large amount of risks and able to profit from them. However, when Hunter betted on natural gas prices, his estimations of making a profit were way off which cost the company $6.6 billion dollars.
The collapse of Amaranth Advisors could have been prevented by that the founder and head of Amaranth Advisors, Nicholas Maounis, could have put a tighter leash on Brian Hunter when it came to how much of the company's assets he could trade. When he hired Hunter to work for Amaranth he allowed him to be responsible for his own trades. If Maounis had some input in Hunter's trading strategies, he might have prevented the company from losing so much money. He should have had a say in how much money was allowed to be invested in a portfolio at a time (Burton).
Another way the Amaranth Advisor collapse could have been prevented is if Brian Hunter had not invested half of Amaranth's assets into the same portfolio. It is not in the best interest for a company to invest half the company's assets into one market such as Hunter did with Amaranth's funds trading them in the energy market. In 2006, when Hunter bid that the energy market and oil market stocks were going to increase in the future, he expected to make a hefty profit. Instead of making money, Hunter lost his company around 70% of their assets. He risked too much of the assets at the wrong time when the economy was beginning to go through a down turn. If Hunter did not risk so much of Amaranth's assets in one market Amaranth would have not experience such a great collapse (Burton).
To prevent the company from losing more money, Amaranth made deals with other financial institutions to take over the energy bets such as Merrill Lynch, JP Morgan, and Citadel. Amaranth had to pay Merrill Lynch $250 million to take over positions, paid JP Morgan and Citadel $2.15 billion to take over the rest of the positions in their energy bets (Davis).
Not only did Amaranth have to pay financial institutions to take over their positions in the energy market, they were also facing a lawsuit against the Federal Energy Regulatory Commission (FERC). The FERC was accusing Amaranth Advisors of manipulating the energy market by selling large amounts of contracts at the last minute before the expiration which led to the settle prices to plummet that worked to Amaranth's benefit. The result of the case ended up in a settlement where Amaranth agreed to pay $7.5 million to the FERC (O'Driscoll).
