Calibration Techniques for Funds Acquisition

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Calibration Techniques for Funds Acquisition

Amaranth Advisors was an American based hedge fund whose head office was located in Greenwich, Connecticut. Nicholas Maonis founded the firm in the year 2000 as an asset management financial company. Amaranth advisors had assets valued at more than $9 billion. The firm lost more than $5 billion in connection with natural gas futures in September 2006. It was one of the largest trading losses in hedge fund operations history. The hedge managed to attract a lot of investors from large employees retirement associations like the San Diego Employees Association while Brian Hunter, the onetime legendary hedge fund trader  succeeded in creating a successful financial firm only to crush it down in less than a month.

The primary trading vehicle for the firm was on convertible arbitrage. After making huge profits during Hurricane Katrina bullish natural gas prices in the year 2005, Amaranth stood a chance of gaining much more after investing in natural gas futures but the plan went awry when natural gas prices failed to increased as expected instead the prices decreased rapidly. Despite spirited attempts by Amaranth management to mitigate the losses presented by the natural gas industry, their efforts were inadequate and they were unable to close down the funds exposure in the public market. Market conditions continued to deteriorate in September when material losses accelerated and over $560 million in trading losses were incurred due to natural gas exposures. As the news of the losses spread through the market the little liquidity left at the firm was quickly dissipated.  Amaranth lost an estimated amount of $420 million daily on the first two weeks of September the year 2006. Finally, the total loss at the end amounted to $6 billion.

The firm had employed professional risk managers who were charged with the responsibility of ensuring that such losses do not occur.

According to the reports issued by Amaranth, the risk management system failed to warm Amaranth management of the looming danger that was posed by the natural gas prices. The risk analysis systems like the VAR (Value at Risk) and stress tests are designed to expose any impending risks in stock pricing and fluctuations in inflation rates.

Amaranth management contends that the huge losses incurred were as a result of a complex combination of unusual market behavior the reduced natural oil prices eroded the company’s book capital while other factors eliminated the company’s liquidity with equal vigor. The aggressive movement of the market against the expectations of the company’s financial risk analyst left no time for the company to liquidate its position. The probability of the market behavior was rated as highly improbable by the company’s risk managers hence Amaranth was ill prepared for the eventuality.

The application of the portfolio theory and the other risk management practices were practically shelved when the Canadian trader Brian Hunter through his own experience on the Hurricane Katrina made huge profits on the bullish natural gas prices of the year 2005, advised and also invested on the natural gas futures (McLean, 2008). 

Amaranth and Hunter were charged by the CFTC (Commodity Futures Trading Commission) for conspiring to manipulate the prices of natural gas. The 2-day hearing by a congressional session found Brian Hunter not guilty of manipulating the prices however he was accused of pushing the prices down while FERC (Federal Energy Regulatory Commission) also charged him with similar accusations. He was fined $30 million but appealed against the fine. The court of appeal in the US set the fine aside in March 15, 2013.

To conclude, the major mistakes that were made by Amaranth were the extremely high leverage bets that were placed on the thought of the natural gas prices improving that no one contemplated even for a minute that the prices would catapult downwards (Anderson, 2006).  The prices went below the support price of $5.5 before dropping further by another 20% in less than two weeks (McLean, 2008). 

Hedging should ideally lower a firm’s risk as hedge firms have both bearish and bullish positions. If one future contract moves in a particular direction then the other should move in the opposite the other hence both positions hedge each other. However most funds make bets based on their leveraged hence the strategy fails to minimize risks (McCall, 2006). Future contracts maintain higher risks than ordinary equities as the leverage is afforded to futures traders. For instance, in equity markets, the traders must provide at least half of the value of the required sale while the futures market requires traders to provide 10% of the value of trade upfront. Hedge funds are also known to borrow heavily from banks a condition which worsens when the funds fail to achieve their targets or when their bets go awry or turn sour (Laurent, 2010).  At the time of its closure, Amaranth was heavily leveraged even before the prices of natural gas begun to tumble. Hunter leveraged ratios peaked at 8:1. For every $1 dollar, Amaranth had borrowed $8 (McCall, 2006).

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