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A Case Study on Risk Management: Lessons from the Collapse of Amaranth Advisors L.L.C.

The speculative activities of hedge funds are a hot topic among market agents and authorities. In September 2006, the activities of Amaranth Advisors, a large-sized Connecticut hedge fund sent menacing ripples through the natural gas market. By September 21, 2006, Amaranth had lost roughly $4.942 billion over a 3-week period or one half of its assets primarily due to its activities in natural gas futures and options in September. On September 14 alone, the fund lost $681 million from its natural gas exposures. Shortly thereafter, Amaranth funds were being liquidated. This paper uses data obtained by the Senate Subcommittee on Investigations through their subpoena of Amaranth, the New York Mercantile Exchange (NYMEX), the Intercontinental Exchange (ICE), and other sources to analyze exactly what caused this spectacular hedge fund failure. The paper also analyzes Amaranth s trading activities within a standard risk management framework to understand to what degree reasonable measures of risk measurement could have captured the potential for the dramatic declines that occurred in September. Even by very liberal measures, Amaranth was engaging in highly risky trades which (in addition to high levels of market risk) involved significant exposure to liquidity risk - a risk factor that is notoriously difficult to manage.