It’s Only Natural…
In August/ September 2006, Amaranth, lost $6 billion after massive natural gas trades went awry. The loss was almost twice the loss when LTCM collapsed. Interestingly, it does not seem to have caused any obvious concern in the market.
Amaranth was a multi-strategy hedge fund. Amaranth Advisors started life as a convertible arbitrage fund (a relatively low risk trading activity). The fund was a recent entrant into energy trading – an infinitely more volatile activity. Just before it blew up, the hedge fund had assets of $9.2 billion. Amaranth's investor base is believed to include funds of funds at major investors such as Goldman Sachs, Morgan Stanley, Credit Suisse, Bank of New York, Deutsche Bank and Man Group. Amusingly, Amaranth claimed to have “best-practice” risk management.
Amaranth made significant returns from energy trading in previous years. In 2005, Brian Hunter, a 32-year old Canadian, made a bet that natural-gas futures would rise. Surging gas prices following Hurricane Katrina made large trading gains for the fund. He earned between $ 75 million to $100 million in 2005. This, by the by, only ranked him a middling 29th highest paid in his profession (according to Trader Monthly) . Hunter was named head of Amaranth’s energy trading operations.
Hunter placed a similar bet in 2006. The major strategy was to buy the March 2007 natural gas futures contract, while shorting the April 2007 futures. The trader wanted to profit from the fact that, historically, natural gas prices increased during winter and then fell after March as demand for heating by consumers decreased. Natural gas prices started falling in early September 2006 as supply became readily available. The trader was hoping that either a hurricane or a cold winter season in the US would eventually push natural gas prices upward.
Unfortunately, the weather did not co-operate. A relatively uneventful hurricane season in the US meant that the March/April 2007 natural gas spread fell sharply in September. Amaranth's trade, which would profit in a widening spread environment, was plunged into negative territory as the March/April spread narrowed from 2.05 points on September 1 to 0.75 points on September 18.
The More Thing Change The More They Stay The same …
The case of Amaranth shows significant parallels to LTCM:
? Risk Analysis – Amaranth believed that they were involved in a low risk activity – “arbitrage”. This was based on the fact that they had offsetting positions – long/ short trades. In reality, such a position is inevitably exposed to correlation changes – the relationship between the two components changing. Inevitably, correlation changes take place rapidly – like a piece of elastic snapping. It is difficult to either anticipate or take corrective action when it occurs. On September 22, Nick Maounis, founder and chief executive of the fund, highlighted the key reason for the losses. “A series of unusual and unpredictable market events caused the funds' natural gas positions, including spreads, to incur dramatic losses”. Correlation bets like the ones that Amaranth and LTCM took are heavily exposed to “event risk”.
? Risk Models – Nick Maounis after the losses surfaced, noted: “Although the size of our natural gas exposure was large, we believed, based on input from both our trading desk and the stress testing performed by our energy risk team, that the risk capital ascribed to the natural gas portfolio was sufficient”. It is questionable that the risk models used were appropriate. For example, correlation risk (one of the main risks in relative value trading) is not generally well captured in traditional risk models. A cursory review of the events shows the inherent limitations of the risk models used. Amaranth took approximately 80 trading days to make $ 2 billion through the end of April and approximately 20 trading days to lose $ 1 billion in May 2006. Amaranth also took twelve trading days to lose a reported $4.44 billion through September 18th or a daily average of close to $ 370 million. Further, when the sale of the energy book was announced on Wednesday, 20 September, the losses were approximately $6 billion and the average daily loss for September expanded to $ 420 million per trading day.
? Liquidity risk - Amaranth had a concentrated, undiversified position in its natural gas strategy. The trader had used leverage to build a very large position. Amaranth’s positions were staggeringly large, representing around 10% of the global market in natural gas futures. For those with an eye to history, LTCM, at one stage, was about 10% of the global US$ interest rate swap market. One study inferred the size of the positions from the reported gains and losses in the firm's energy book. On a high-activity day, the market trades more than 100,000 contracts, while in quieter times that figure might only be 50,000-60,000. It is estimated that Amaranth held well over 50,000 natural gas contracts. There are other more obvious signs of the liquidity risk. In an interview in July 2006, Bruno Stanziale, a former Deutsche Bank colleague of Brian Hunter and now at Société Générale, commended Mr. Hunter contribution to society at large. Hunter and Amaranth were, it seemed, helping the market function better and gas producers to finance new exploration, such as by agreeing to buy the rights to gas for delivery in 2010. Mr. Stanziale was effusive in the qualities of the trader. “He’s opened a market up and provided a new level of liquidity to all players”. He seemed to have confused the trader with Mother Theresa. That should have been warning enough. Hunter’s trading provided telling clues. He is alleged to have bought increased numbers of contracts that he already owned, presumably attempting to drive up prices of contract he already owned. This is known as the Nick Leeson gambit in trading. Of course, when the losses occurred, Amaranth could not exit its positions due to the lack of liquidity. “The markets provided no economically viable means of exiting those positions. Despite all our efforts, we were unable to close out the exposures in the public markets.” Nick Maounis moaned in a regretful aria that reprised the song made famous by the principals of LTCM in 1998. In the end, Amaranth were forced to transfer its energy positions to JP Morgan Chase and Citadel Investment Group at an apparent $1.4 billion discount to their mark-to-market value compounding the losses to investors.
Welcome to the Slaughterhouse!
As with all losses, the markets had the last word. As news got around of Amaranth’s problems, other traders took advantage of its problems to make money. One trader was quite open: “When people get a sense that someone is on the ropes, they're going to exacerbate the problems that he has. Those with risk capital are going to short whatever he has, believing the guy will have to capitulate and that they will be there to take his capitulation selling”.
But what of the sophisticated fund-of-funds that had investments in Amaranth? It shouldn’t have been a surprise. Amaranth’s losses followed the failure of another US hedge fund, also due to natural gas trading. MotherRock, an energy-focused hedge fund with $400 million under management, collapsed in late July 2006. Perhaps like Amaranth their sophisticated risk management systems had been caught by surprise. A spokesman for Amaranth gave the following detailed analysis of the losses: “We did not expect that the market would move so aggressively against our positions!”
Perhaps like with LTCM the returns had dazzled them. A sad reality of risk management failures is that most people tend not to look beyond the profits to the reasons on which it depends. In a speculative environment this critical ability greatly diminishes.
In the practice of quantitative finance, the best advice that one can offer is something from over 100 years ago. Mark Twain once remarked: “It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.” Both LTCM and Amaranth are reminders that this observation is accurate and relevant.
© Satyajit Das 2007; All rights reserved.
The above is adapted from Traders Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das (2006, FT - Prentice Hall, London, ISBN 0273 70474 5) available at all good book stores or online at www.pearson-ed.com.
Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management. His works include Swaps/ Financial Derivatives Library – Third Edition (2005, John Wiley & Sons) (a 4 volume 4,200 page reference work for practitioners on derivatives) and Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons). He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), an insider's account of derivatives trading and the financial products business filled with black humour and satire. The book has been described by the Financial Times, London as " fascinating reading … explaining not only the high-minded theory behind the business and its various products but the sometimes sordid reality of the industry". He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (2006, New Holland), an unique travel narrative offering passionate and often poignant insights into the natural world and the culture of eco-travel.