The Amaranth Advisors was an American hedge fund that incorporated high levels of risk taking in achieving profits. As a multi-strategy hedge fund, the corporation would pool capital for investors and use it for investment into various assets in any market. Similar to numerous financial institutions, the corporation had a complex portfolio construction and significant risk management strategies that would help mitigate events that may threaten the company’s ability to achieve profits (Davis, Sender, & Zuckerman, 2006). The limited liability company was founded in 2000 by Nicholas Maounis and headquartered in Greenwich, Connecticut. The primary investments of the company are liquid assets and as a hedge fund its use of leverage in achieving profits is not capped by regulators. Since the establishment of the firm, convertible arbitrage was its main medium of profit. However, this would change during the years 2004 and 2005 soon after the hiring of Brian Hunter.
The new recruit was previously working as head trader at the Deutsche Bank until the end of 2003. It was in December of the same year that under the guidance of Hunter the aforementioned bank experienced a loss of $51 million in a span of a week (Goodman, 2014). Though the organization claims that the incurred loss was a result of unforeseeable developments in the market, it is evident that the incident causes a decline in the relationship with Hunter. He is soon hired by Amaranth who name him as co-head of the energy desk and give him control of his own trades (Davis, Sender, & Zuckerman, 2006). Hunter made an optimistic decision on natural gas prices which results in large profits after the hurricanes interrupt production and cause prices to increase. In this regard, the hedge fund company identifies the importance of the new recruit and believe that he will make similar profits in future trades.
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Expectation of Profit and Risks Hedged
During the year 2005, Hunter’s success in generation high level of income for Amaranth Advisors helps cement his credentials and reputation in the firm. Unsurprisingly, the organization had reached a record high of $9.2 billion in assets under management. Hunter would be given $5.7 billion to invest in energy. In its history, the corporation was more conservative in this practice as it consistently brought in returns of around 30% a year. Using futures contracts, Hunter was able to make much more than was the case in the previous years. Hurricanes Katrina and Rita in 2005 were the primary factors that led to the profits earned. In January of 2005, the natural gas prices were at their lowest in the year before peaking in October and November (Davis, Sender, & Zuckerman, 2006). When gas production was interrupted by the natural disasters the prices shot up by three times. It was in this case that the company was able to earn over $1 billion and building a reputation for Hunter. Amaranth would reward him with a bonus of between $75 and $100 million for his successful year (Goodman, 2014).
The following year, the organization could not allow Hunter to leave as they gave him access to a much larger capital to invest. In this case, the futures contract is a legally binding agreement usually made at the trading floor of a futures exchange. An individual or institution establishes a commitment to buy or sell a commodity at a predetermined price and at a particular time in future. These contracts are standardized as a means of ensuring ease of trading on a futures exchange. Additionally, certain assets being traded are detailed in quality and quantity of the commodity at hand. Following the success that the hurricane season had brought to the corporation with billion dollar returns, it was only natural for Hunter to make a similar investment (Davis, Sender, & Zuckerman, 2006). Despite the fact that meteorologists expected less severe storms, He placed his investment though details of the exact amount are not released to the public. In this regard, the company intended to achieve large amounts of profits from the hedged position. The futures contracts are depicted as a major risk, but one that could reap immense rewards for the firm.
Loss Occurrence
There are a number of factors that could highlight reasons why the firm experienced losses in the onset of the second year. First and foremost, Hunter and Amaranth Advisors incorporated the events of the previous year as the basis of setting up investments for the year 2006. There was nothing else taken into consideration by the firm in making the bullish decision. Despite attempts by meteorologists to provide advice on the hurricane season being less severe, the firm expected that the anticipated storms would be able to push through the prices of the natural gas significantly influencing their ability to increase significantly. The extreme confidence in Hunter and the excessive risk taken by the firm worked against their investment resulting in losses of over $6 billion (Goodman, 2014).
The futures contract is one that currently receives little regulation from the federal or state governments. In this case, hedge funds among other organizations conduct significant research on the market and identify the possibility of increased prices of a commodity. Assuming that the current price of natural gas is at $50 per unit, the firm will estimate that due to the possible occurrence of natural disasters the price of the commodity will drastically increase. In the energy market the prices are always shifting. At one point, the prices could be steadily gaining resulting in significant profits for the company, but the availability of supply and resources could result in a free-fall in market prices. The hedge fund is intended to alleviate risk of buying goods at steep prices that occur when natural disasters prevent production.
Amaranth Advisors had participated in energy trading for a few years prior to the recruitment of Hunter. However, its practice was rooted in a convertible-bond trading which is a less volatile market and different from the futures contracts. There was significant confusion in paper trading gains and cash profits. In this case, Hunter implemented the spread strategy for the period between the March and April 2007 contracts. He had bet that the spread would widen greatly between the two months but they narrowed in early September. He further increased the losses of the company by doubling down. In this case, hedge funds with a huge portfolio of assets are more likely to receive credit from other financial institutions. The borrowed money helps initiate new positions which resulted in the peak of 8:1 ratio. In this regard, the organization could not be able to pay back the borrowed money as the market prices dwindled.
Describe the outcome of the losses
Aftermath
Following the lack of a significant hurricane, the production of natural gas went on as usual causing the gas prices to plummet. The forecast of a mild winter also sent futures prices down. In mid September 2006, the portfolio lost $560 million in a single day. The Commodity Futures Trading Commission (CFTC) and the Federal Energy Regulatory Commission (FERC) open investigations against Amaranth Advisors by charging them with attempting to manipulate the prices of natural gas and market interference respectively. The FERC judge ruled against the trader Hunter as he was found to have violated the Anti-Manipulation Rule and was fined $30 million. However, the trader appeals shortly and the US Court of Appeals for the District of Columbia Circuit identifies that the FERC had no jurisdiction in the futures market where he traded. Hunter is listed among Wall Street Journal’s rogue traders in history in 2011 before later being fined $750,000 with the CFTC and is restricted from trading in any CFTC-related natural gas products (Rimkus, 2017).
Institution Bankruptcy
The organization is depicted to experience high levels of losses in the events of a market free-fall in prices of natural gas. The organization attempted to manipulate the market by increasing their purchase of futures contracts despite significant indication that the market will not experience troubles from natural disasters. In this regard, the principals of Amaranth failed to pull out of the race despite a clear lack of profit and continued decline in the market. The corporation settles charges against them by paying a civil penalty fine of $7.5 million with CFTC and FERC (Rimkus, 2017). The assets under management of the company drop from $9 billion to $4.5 billion (Rimkus, 2017).
Prior to these events, the company boasted having the most effective risk management system in the hedge fund industry. The company is unable to effectively achieve its profitability status as it seeks to sell its portfolio to other corporations. The organization received a low bid of $2.5 billion from JP Morgan Chase and Citadel Investment Group. The company was forced to liquidate its assets in an effort to pay off investors who had seen their investments swindled and taking too much risk (Rimkus, 2017). The corporation is unable to restore its status in the market and the trust from its investors is essentially lost.
What can be learned from the case?
Measures to Prevent Recurrence
It is evident that there has been little suggested measures of preventing possible occurrence of a similar debacle to that of Amaranth Advisors LLC. The drastic fall of the multi-strategy corporation is depicted to have likeness to the Long-Term Capital Management (LTCM) that collapsed in the late 1990s. It was initially founded in 1994 experiencing significant profits of 21%, 43% and 41% in its first three years. This is a similar occurrence to that of Amaranth, before it eventually lost $4.6 billion in four months. It is evident that transparency is a necessary factor in the financial market (Dreyfuss, 2013). The organization does not disclose information to the investors who believe that the corporation will eventually achieve a significant profit and increase the amount of capital offered. The corporation should be obligated to demonstrate high levels of communication with its clients such that they can make a decision whether the risk is worth taking. Additionally, improving surveillance of the traders is a necessary component. The organization had earlier practiced a multi-strategy options trading that would allow investment in an array of asset classes. However, upon the recruitment of Brian Hunter, the company shifted majority of its risk investment on natural gas products (Dreyfuss, 2013). The company was investing more that the consumption of natural gas in the US which should have been a major red flag. The incorporation of significant regulation practices should result in minimal financial deficit.
Implementation and Personal Views
The implementation of such practices is yet to be seen. Capital management companies continue to exist and put their investors in high risk high return situations. The primary factor causing the excessive risks in the financial management market is the lack of fees. In this case, when the company experiences a flat line or lack of change in market prices, the clients are not obligated to make payments for the services offered. In this regard, it would be impossible to implement the changes on the particular company as the losses were excessive leading to bankruptcy. The enforcement of the measures would result in a difficult situation where the corporation has to cope with significantly less risky practices of trading in the market.
References
Davis, A., Sender, H., & Zuckerman, G. (2006) What went wrong at Amaranth Advisors. Pittsburgh Post-Gazette, Retrieved from http://www.post-gazette.com/business/businessnews/2006/09/20/What-went-wrong-at-Amaranth-Advisors/stories/200609200143
Dreyfuss, B. T. (2013) Hedge fund’s wild side: The man who lost $8 billion . Salon, Retrieved from https://www.salon.com/2013/06/01/hedge_funds_wild_side_the_man_who_lost_8_billion/
Goodman, L. M. (2014) The 'rogue trader' who got away with it . Newsweek, retrieved from http://www.newsweek.com/rogue-trader-who-got-away-it-271105
Rimkus, R. (2017) Financial Scandals, Scoundrels & Crises: Amaranth Advisors . CFA Institute, Retrieved from https://www.econcrises.org/2017/02/01/amaranth-advisors/
