Case Study: Amaranth Derivatives Losses

Background of the case

This article describes the market manipulation case by Amaranth Advisors who had exposure to natural gas futures, swaps and options derivatives contracts as Calendar Spreads.

Amaranth’s trading strategy was long winter and short non-winter natural gas futures contracts. In financial market terminology this is called a Calendar Spread. This strategy was designed to provide compensation to speculators, natural hedgers and storage operators. Significant leverage was used to run these positions.

These positions were run by the head of the energy trading desk Brian Hunter.

Causes of the losses

An investigation in the case revealed that Mr. Brian Hunter manipulated NYMEX natural gas futures prices downward and profited because Amaranth held offsetting swap positions. Contrary to the report by Mr. Hunter’s expert, the price movement was consistent with a manipulative scheme. Mr. Hunter’s expert claimed that no “price reversal” occurred, but Dr. King found statistically significant evidence that prices were driven downward and subsequently recovered, consistent with the alleged manipulation.

Amaranth’s trading behavior during the at-issue time periods was found to be unusual when compared with the behavior of other market participants and Amaranth’s own historical behavior. Additionally an examination of news events and fundamental demand and supply factors before and during the alleged periods of manipulation found no evidence that news or market fundamentals caused the at-the-issue price movements.

Market risk was really high in this case but may have been reasonable. Liquidity risk was excessively and imprudently high. In September 2006, Amaranth lost about $4.942 billion or about 48% of the fund value at quite a rapid pace. These losses came after the purchase of the Mothers Rock NG position to neutralize their own exposure. This position started losing money consistently on 08-Sep-2006.

The Aftermath and the Lessons Learned

Nine of the ten Amaranth defendants agreed to pay $7.5 million pursuant to an uncontested joint settlement.

The key lessons are as follows – Regulators and/or practitioners need better measures of liquidity risk.Transparency across similar markets would be useful. More standard measures of liquidity risk needed to be developed after the event. Better standards of internal risk management were needed and a point to be noted is that spread positions are not arbitrage positions. The MBS and the CDS market are exchange-traded rather than OTC. The liquidity risk is on roll-over financing for risk positions and riskier than history suggests.

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