Amaranth Collapse

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or firms were willing to buyout their position. As a result of the illiquidity in the natural gas futures market, Amaranth had to accept a low-bid offer from Citadel Investment Group and JPMorgan Chase as they did not have an alternative option to sell their energy holdings.7

Strategies to Prevent Loss and Lessons Learnt

About half of the fund’s capital was in the energy sector, which created 75 percent of the funds profits.8 In late July 2006, Amaranth held natural gas contracts representing a volume that could supply the amount of natural gas used by U.S. residential consumers nationwide in a month.9 This heavily exposed Amaranth to unsystematic risk, as returns were directly tied to the energy sector. One key strategy that could have prevented the financial loss is to diversify investments within the energy sector or pursue investments in other sectors to mitigate unsystematic risk. For example, Amaranth could have invested in other future markets such as metals, livestock and agriculture. When prices for natural gases collapsed, diversification into these other sectors would have minimized losses.

6 Hilary, T. (2008). “A Case Study on Risk Management: Lessons from the Collapse of Amaranth Advisors”. Edhec Business School. 7 Burton, Katherine and Matthew Leising (2006). “Amaranth Says Funds Lost 50% on Gas Trades This Month”. Bloomberg News.

8 Hilary, T. (2008). “A Case Study on Risk Management: Lessons from the Collapse of Amaranth Advisors”. Edhec Business School. 9 Skyrm, Scott. “Brian Hunter: Amaranth Rogue Trader.” Scott ED Skyrm.

Another trading strategy that Hunter could have used to minimize losses is by reducing overall net exposure by taking a larger short position in natural gas futures contracts. By doing so, Hunter would have made gains on the short position as the price of natural gas fell. This would have offset a portion of the losses incurred on the long future contracts.

One management strategy that Amaranth should have implemented is to establish investment guidelines outlining the size and scope of investments in an effort to mitigate the funds risk. Due to Hunter’s previous successes in the energy futures sector, Amaranth named Hunter the co-head of the firm’s energy department and gave him full control over futures trades. Critics have argued that this weakens the risk- management structure necessary in order to keep ambitious traders in check.10 Furthermore, having a monitored and standardized system to govern trading activities will protect the fund against rogue traders with highly leveraged bets that ultimately jeopardize the fund’s financial state. Finally, this case teaches the key lesson that past market behaviour does not equal future market behaviour. Therefore, scenario analysis and risk management should be used to minimize the impact of adverse or unplanned events that drive down the value of investments.