Managing Hedge Fund Risk and Financing: Adapting to a New Era

Amaranth Advisors LLC (2006)

Amaranth Advisors lost roughly US$6 billion in the natural gas futures market in September 2006. Amaranth had a concentrated, undiversified position in its natural gas strategy. Employing significant leverage, its positions were staggeringly large, representing around 10 percent of the global market in natural gas futures. Amaranth failed to factor in the size of its positions in comparison to the quoted value for small daily transactions and to set aside a sufficient liquidity reserve. Given its concentration in the security, it failed to correctly assess and reserve for its inability to sell its futures contracts at or near the latest quoted price. Hedge funds need to manage asset liquidity risk explicitly.

In Amaranth's case, the concentration was far too high and there were no natural counterparties when it needed to unwind the positions. Part of the loss Amaranth incurred was due to asset illiquidity. Regression analysis on the three-week return on natural gas futures contracts from August 31, 2006 to September 21, 2006 against the excess open interest suggested that contracts whose open interest on August 31 was much higher than the historical normalized value experienced larger negative returns.¹