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Lessons Learned:

1. Lessons for Investors:


Full and timely position transparency from the investors would not have helped identify the red flags
about the hedge funds exposure. This is because since May, investors knew that a typical spread( up or
down months) for the energy portfolio was about 11%. Thus the monthly volatility of the energy
strategies had been about 12% and a 24% loss in the funds energy trades, in a single month, would not
have seemed unusual, corresponding to a two-standard deviation event.
Investors instead should adopt an examination method of the funds monthly sector level profit and loss
account to identify sufficient red flags. Subsequently they can also do an analysis of the fund liquidity
risk to better understand the precise position of the fund.
2. Lessons for Fund of Fund Risk Management
One would expect that the fund did not entirely accumulate its Natural Gas positions through the
exchange-traded futures markets; one might assume that a meaningful fraction of its Natural Gas
strategies was also acquired through the Over- the-Counter (OTC) derivatives markets.
Even if a substantial amount of the Funds positioning was through the opaque OTC markets, an
examination of the notional value of Amaranths positions versus the open interest in the back-end of
the New York Mercantile Exchange (NYMEX) futures curve would likely have shown that the funds
positions were massive relative to the prevailing open positions in the futures markets. This would have
provided a red flag of the liquidity (or lack thereof) of the funds positions.
After the fact, we can do a returns-based analysis of what the likely sizing of the funds positions were,
based on the publicly reported strategies of the fund, and what the publicly stated path of the strategys
p/l had been since June.
This procedure is described in Appendix A: Reverse- Engineering Amaranths Natural Gas Positions.
We do not represent that our analysis shows the funds actual positions. Instead, our returns-based
analysis shows positions that, at the very least, were highly correlated to Amaranths energy strategies.
According to our returns-based analysis, the funds positions were indeed massive relative to the open
interest in the further-out months of the NYMEX futures curve.
3. Lessons for the Hedge Fund Industry
There are at least three analogies to the LTCM debacle.
[A] Risk metrics using recent historical data would not have been helpful in understanding the
magnitude of moves during an extreme liquidation- pressure event.
There was a preview of the intense liquidation pressure on the Natural Gas curve on 8/_/06, the day
before the energy hedge fund, MotherRock, announced that they were shutting down.
This natural-gas-oriented hedge fund had been founded by a former NYMEX President, Robert
Collins; and its shutdown sent shock waves throughout the industry.
A near-month calendar spread in Natural Gas experienced a 4.5 standard-deviation move intraday
before the spread market normalized by the close of trading on 8/_/06. We assume that this move
occurred because of MotherRocks distress.
We might assume that MotherRock had been short the NG U-V spread; that is, they were long October
and short September. Why make this assumption? The brief intense rally in this spread on 8/_/06 is
consistent with the temporary effects of a forced liquidation of a short position in this spread.
As it turned out, the scale of MotherRocks losses, which were likely up to $300 million, was small

Figure 2
compared to Amaranths September experience.
In Appendix B: Recent Volatility Analysis of Funds Reverse-Engineered Positions, we discuss what
the volatility of Amaranths energy trades is likely to have been, based on a returns-based analysis.
Figure _ reproduces one of the graphs in Appendix B.
As of the end of August, the daily volatility of Amaranths inferred Natural Gas positions was _%
based on the previous three months of trading experience.
The funds loss on Friday, September 15th (inferred from Appendix As returns-based analysis) may
then have been a 9-standard-deviation event.
Jorion (1999) informs us that based on LTCMs target volatility, the scale of LTCMs losses in August
1998 would have been an 8 standard- deviation event.
[B] The strategies that LTCM and Amaranth employed are and were economically useful.
LTCMs core strategy had been relative-value fixed-income investing.
Relative-value fixed income hedge funds have historically allowed international banks to lay off
illiquid fixed-income risk. These hedge funds then have traditionally hedged this exposure with highly
correlated, but more liquid, instruments (although post-1998, they have no longer done so with
Treasuries).
In the case of Natural Gas, there is a natural commercial need for an institution to provide a return for
storing Natural Gas for later use during peak winter demand. In the United States, there is also
inadequate storage capacity in Natural Gas for peak winter demand. Therefore, the winter Natural Gas
contracts have been trading at ever increasing premiums to summer and fall months to (1) incentivize
storage; and provide a return in the future for creating more production and storage capacity. The
natural commercial position is to lock in the value of storage by buying summer and fall Natural Gas
and selling winter Natural Gas forward. There has been no natural other side to this trade in sufficient
commercial magnitude, which is where the usefulness of such financial participants as Amaranth
comes into play. The hedge fund could have also provided liquidity to commercial participants by
buying winter Natural Gas and then hedging itself with spring contracts.
In Appendix C: Background on the U.S. Natural Gas Market, we discuss a number of the technical
features of the Natural Gas market. We do so in order to provide a better understanding of Amaranths
Natural Gas strategies.
[C] Even If a Strategy is Economically Viable, All Strategies Have Capacity Constraints.
LTCMs well-known strategy of (for example) buying (relatively illiquid) _9.5-year Treasury bonds
and shorting 30-year on-the-run Treasury bonds is obviously defensible. But even the Treasury market
can come under liquidation-pressure stress when position sizes reach sufficient magnitude, as seen
during the LTCM crisis.
For Amaranth (and other energy hedge funds), the benefit of providing liquidity to Natural Gas
producers and merchants is as follows. If a trader were long winter Natural Gas versus other sectors of
the Natural Gas curve, that traders portfolio would perform very well during Hurricanes (like _005s
Hurricane Katrina) and also during exceptionally cold winters (such as during February _003.) In
summary, the hedge fund would be positioned for extraordinary gains if such weather shocks occurred.
But the issue again becomes one of appropriate sizing relative to a funds capital base.
4. Lessons for Energy Hedge Fund Risk Management
Veteran commodity traders do use measures like Value-at-Risk calculated from recent data to
evaluate risk. But they also employ scenario analyses to evaluate worst-case outcomes. A natural
scenario analysis for Amaranth would

have been to examine what the range of the Natural Gas spread relationships had been in the
past. In that case, one would have found how risky the funds structural position-taking was in its
magnitude.
5. Lessons for Multi Strategy Hedge Fund Mangers
Amaranth sought profits in shares of merging companies, distressed debt and stocks. It made a
push into energy trading in 2002, hiring former Enron Corp. trader Harry Arora to lead the effort.
Maounis's style was to focus on raising money from investors, deciding how it should be
allocated and hiring the best traders he could find. He did not micromanage, preferring to give
more leeway to traders who did well,.Maounis knew who was making and losing money, though
he mostly left the details to department heads and the risk management team headed by Rob
Jones. Using this model, Amaranth had 15 percent-annualized returns since its inception -- more
than double the average performance of multi strategy funds for the same time period, according
to Hedge Fund Research.
The commodity markets do not have natural two-sided flow. For experienced traders in the
fixed-income, equity, and currency markets, this point may not be obvious.
The commodity markets have nodal liquidity. If a commercial market participant needs to
initiate or lift hedges, there will be flow, but such transactions do not occur on demand.
For experienced commodity traders, a key part of ones strategy development is a plan for how to
exit a strategy. What flow or catalyst will allow the trader out of a position? In the case of
Amaranth, there was no natural (financial) counterparty who could take on their positions in
under a week (or specifically during a weekend when the fund initially tried to transfer positions
to a third party). The natural counterparties to Amaranths trades are the physical-market
participants who had locked in either the value of forward production or storage. The physicalmarket participants would likely have had physical assets against their derivatives positions so
would have had little economic need to unwind these trades at Amaranths convenience.
Another key lesson from the Amaranth debacle is the understanding of commodity markets and
that they do not have a natural two-sided flow. For experienced traders in the fixed income,
equity, and currency markets, this point may not be obvious.
The commodity markets have nodal liquidity. If a commercial market participant needs to
initiate or lift hedges, there will be flow, but such transactions do not occur on demand.
For experienced commodity traders, a key part of ones strategy development is a plan for how to
exit a strategy. What flow or catalyst will allow the trader out of a position? In the case of
Amaranth, there was no natural (financial) counterparty who could entirely take on their
positions in under a week (or specifically during the weekend of 9/16 and 9/17/06 when the
fund initially tried to transfer positions to a third party.) The natural counterparties to
Amaranths trades are the physical-market participants who had either locked in the value of
forward production or storage. The physical-market participants would likely have had physical
assets against their derivatives positions so would have had little economic need to unwind these
trades at Amaranths convenience.
6. Lessons for Policy Makers
The derivatives markets are wonderful risk-transfer mechanisms for many economically essential
activities. Amaranth was indeed providing an economic service. It is economically desirable for the
capital markets to incentivize the creation of sufficient storage capacity of Natural Gas for peak winter
demand in the U.S trader out of a position? In the case of Amaranth, there was no natural (financial)
counterparty who could take on their positions in under a week (or specifically during a weekend when
the fund initially tried to transfer positions to a third party). The natural counterparties to Amaranths
trades are the physical-market participants who had locked in either the value of forward production or
storage. The physical-market participants would likely have had physical assets against their
derivatives positions so would have had little economic need to unwind these trades at Amaranths
convenience.
But obviously the magnitude of Amaranths positions was inappropriate for the size of their capital
base, as with LTCM. In Appendix D: The Post-Liquidation Experience, we note that the assumed
Amaranth spreads have (thus far) stabilized since the positions were transferred to two financial
institutions.

There appears to be a double standard being practiced by the CFTC regarding position limits
between the largest derivatives players [like J.P. Morgue] and smaller ones [like Amaranth].
Issues of concentration [commodities laws] are enforced on smaller players and ignored on the
preferred players. This preferential treatment extends to this day as the CFTC continues to look
the other way while J.P. Morgan and HSBC increasingly dominate the short open interest in
COMEX silver even as reported shortages of physical metal continue to crop up at national
mints around the world.
[1] One would expect there to be increased care by financial institutions in participating in the
commodity derivatives markets.
According to a California Public Employees' Retirement System (2006) presentation, the size of
the commodity derivatives markets is less than 2% of global asset values. This means that the
commodity derivatives markets are relatively small for sophisticated financial-market
participants. The Amaranth case shows how just one large hedge fund can effectively overwhelm
an entire commodity futures market, the U.S. natural gas market.
Given the size of penalties envisioned in the FERC order for gaming of the energy markets, one
might expect increased vigilance by global trading entities in evaluating the impact of their
activities on these relatively small markets.
[2] There has been an obvious regulatory gap in covering over-the-counter energy derivatives
trading.
There had been an explicit body-of-law in the U.S. covering futures trading and physical energy
transactions, but clearly not for over-the-counter energy derivatives trading.
This meant that effectively it was only Amaranths credit providers and investors who could
constrain Amaranths natural-gas trading activities. In retrospect, neither set of participants had
been effective in this regard.
Unlike post-mortems after the Long-Term Capital Management debacle, there has not yet been
an official examination of the role of Amaranths credit providers in allowing their client to amass
such hugely concentrated positions in natural gas across both exchange- traded and over-thecounter platforms. We would expect this to happen before the complete history of and lessons
from the Amaranth debacle can be written.
[3] Even though the Amaranth collapse did not lead to wider problems in the financial markets,
one should still be cautious about concluding that the alternative investment industry has the
wherewithal to absorb major hedge fund failures.
In the Long-Term Capital Management crisis, the hedge-fund-in-distress had positions that were
highly correlated or identical to the core positions held by leveraged, money- center banks.
In the Amaranth crisis, the funds key risk positions were calendar spreads in the U.S. natural gas
derivatives markets; these are not positions that are central to the risk-taking activities of the
main international banks. Therefore, the impact of Amaranths losses was (arguably) largely
confined to its investors.
Also, it is likely that physical natural-gas market participants were the ultimate risk takers on the
other side of Amaranths trades, and so benefited from the temporary dislocations that ensued
from the funds distress. In other words, it does not appear that the commercial natural-gas
industry was damaged by this financial crisis; in fact, commercial-market participants likely
benefited.
Natural gas commercial hedgers would have earned substantial profits had they elected to
realize their hedging windfall during the three months that followed the Amaranth debacle, as
discussed in Till (2007c).
A true test of the alternative investment industrys robustness would have to be one where a
large hedge fund not only became distressed, but also held substantial positions that were highly
correlated to those held by the major international banks.
[4] The Amaranth debacle will eventually be seen as one of the consequences of the massive
liquidity that had severely mispricing all manner of risky assets.
Ultimately one would hope that the market-place would provide a sufficient disciplining
mechanism in preventing future Amaranths. After all, no hedge-fund investor would want to see
a swift 70% decline in the value of their investments. Perhaps the lesson for global investors in
2006 and 2007 will be that value matters: one should not pay historic prices for forward U.S.

winter natural-gas prices relative to non-winter months; just like one should not invest in the U.S.
sub-prime mortgage market without adequate compensation for default risk, as explained by
Tavakoli (2007).