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Risk Governance Amaranth Advisors G
March-April spread trade had a $0. Loss for each contract and this is very small for the company to lose $2. 5-2. 8 ban in 15 days, since such massive positions required to lose that much were not possible. Same for scenario 2, where the spread loss Is $1. 5, given a size proportional to open Interest of 389,226. However as per scenario 3, the spread loss Is $3. 5 with contract size on winter contracts of 484,364 giving an overall loss of $1. Ban in line with the breakdown provided. However since it is impossible for any one trader to hold the whole market, t is highly likely that Amaranth held positions which were combinations of the above three.
Amaranth were taking spread bets. The advantage of spread bets is taking directional bets with hedging of underling’s volatility in market. Profits depend only on the term structure of the future curve since the underlying for both the contracts are same. Amaranth was betting winter supplies would be lower and hence prices would be higher compared to that of the summer prices. However if the spread widens in short period, as in the case of Amaranth, the risk would be higher. If the short contract increases in price, the long contract is priced cheaper and hence can be increased in size if the shock Is only short lived.
If not, the losses would get much worse. Q. Liquidity constrains play any role? Please, explain. Liquidity constraint is considered to be major reasons for the collapse of Amaranth’s hedge fund. Amaranth’s strategy consisted of long winter natural gas contract months and short non-winter natural gas contract months. Amaranth’s trading position in ENZYME and ICE, were extremely large compared to average daily trading illume of the largest natural gas futures. Sometimes, the positions were hundreds of times the 30-day average dally trading volume.
It Is believed that Amaranth had positions of nearly 100,000 contracts in a single maturity month. Despite being aware of the liquidity issue they increased the size of their positions from the end May to the end of August, believing that the market was wrong and they were right. It is clear that they were taking immense risk with respect to liquidity. Were too big and concentrated. It was impossible to liquidate the holding, without incurring substantial loss. They were afraid that selling their position might decline the prices even more.
Liquidity constraint is the major problem they faced, to get rid of the positions. Finally, they reached a deal with JP Morgan and Goldman Cash, to get rid of their positions. Six billion dollar was the cost they had to pay for liquidating their position, which led them to finally close their hedge fund. Q. Could anyone have seen it coming? Why? Brian Hunter was inconsistent with his performance and was betting on general aspects with respect to energy trades and had a confidence bias as it helped him gain recognition within Amaranth.
He consistently bet long the winter spread and also took the risky position of going long in the 2006. Additionally, he went long the widow spread which shows a huge exposure to the on directional bets he was placing and putting in huge investment for the same without considering factors which would impact energy future prices. The main issues which caused the spread to increase and generate returns for hedge funds in energy trades was the problems of delivering energy during winters u to hurricanes and the increase in demand due to extreme winters.
As per weather forecasts with low hurricane or meek hurricane possibilities and built up inventory for energy we already can see one factor for rising prices is negated as delivery will not be a problem. Additionally, a mild winter is predicted which reduces the influence of demand increases on the prices. Another issue that caused major losses is the large unwinding of the position, which causes liquidity in the markets. At the time of unwinding Hunter has to give Goldman additional incentive to help unwind Amaranth’s position as he does not wish to influence market prices.
The huge loss in the position was very likely. It could have been predicted at a somewhat earlier time with the risky positions held by Amaranth (Hunter). In addition to his one directional bets on energy the weather forecasts, inventory buildup and low probability of delivery issues for natural gas kept the future prices low and caused huge losses at the time of exit due to liquidity concerns because of the large one directional positions held by Amaranth with regard to energy futures.