Factor Exposures and Hedge Fund Operational Risk: The Case of Amaranth

Abstract

Hedge fund performance and risk measurement continues to present intriguing challenges to both academics and practitioners. Risk-return measures that are solely based on historical return series tend to provide limited information and the marginal new information revealed by another quantitative measure tends to be small, and approaches zero once three or more measures are considered. In this article we will examine the ris exposures and performance characteristics of Amaranth Advisors LLC. Amaranth Advisors LLC was created in 2000 as a multi-strategy hedge fund. Beginning operations with approximately $600 million in capital, it sought to employ a diverse group of arbitrage trading strategies particularly featuring convertible bonds, mergers and utilities. In 2002, Amaranth added energy commodity trading to its slate of strategies with JP Morgan Chase clearing its commodity trades. On August 4, 2006 NYMEX examined Amaranth’s positions and calculated that Amaranth held about 51% of the open interest in the September natural gas futures contract which would expire at the end of the month. NYMEX decided that this was too large and on August 8 NYMEX compliance officials notified Amaranth of their concerns. Amaranth complied with NYMEX’s directions and subsequently reduced its September and October positions. However, at the same time Amaranth increased its positions in September and October ICE contracts such that their overall positions in natural gas rose. The events that followed in late August and September led to huge losses with Amaranth losing significant value.