News this week that a 32 year old Canadian energy trader by the name of Brian Hunter recently lost approximately $5 Billion dollars in a period of only one week in the natural gas market caused an uproar on Wall Street.
Investors in Amaranth Advisors – the Connecticut based multi billion dollar
hedge fund for which Mr. Hunter continues to trade, saw the value of their
investment decline by 35% after being up as much as 20% this year -- an overall
drawdown of 50% all in a remarkably short period of time Some
institutional clients such as the San Diego County Employees Retirement
Association were badly hurt. SDCERA which oversees more than $7 billion on
behalf of retirees and employees of the county, invested $175 million in
Amaranth last year, according to hedge fund industry publication Alpha magazine.
But with Amaranth down about 35% so far in 2006, SDCERA may have lost more than
$50 million on its investment this year alone.
While Amaranth’s
fate underscores the volatile nature of the hedge fund business (in a great
example of understatement, SEC Chairman Christopher Cox stated., “Big losses at
Amaranth Advisors LLC demonstrate that investing in hedge funds can be risky”)
it may also contain wider ramifications, impacting other seemingly unrelated
markets such as foreign exchange.
Amongst financial instruments the
natural gas market is not very large. Average daily volume is approximately
10,000 contracts with notional value of little more than $50,000 per contract
translating into about $500 Million of daily turnover. Open interest at present
is nearly 79,000 contracts with total notional value of just $4 Billion. At
first glance this data only confirms the extreme concentration of Mr.
Hunter’s positions and highlights the massive amount of risk implied in his
bets. However, the illiquidity of the natural gas market and the sheer size of
Mr. Hunter’s losses also demonstrates Amaranth’s central problem – how to unwind
these positions in an orderly fashion?
Forced Liquidation – A
nightmare for some and opportunity for others
In a letter to his
investors, Mr. Nicholas Maounis, Amaranth’s founder stated, "We are in
discussions with our prime brokers and ... are working to protect our investors
while meeting the obligations of our creditors," While his words attempt to
reassure his clients, in reality Mr. Maounis is trapped. The Amaranth fund
now finds itself in the worst possible situation for any
trader to be - it must meet its margin obligations or face forced and
wholesale liquidation of its positions. Forced liquidation is a nightmare for
those traders caught on the wrong side of the market because it demands
immediate disbursement of positions regardless of price.
On the flip
side however, forced liquidation offers the closest possibility of a risk free
trade for other traders in the marketplace. These traders understand that the
financial instrument in question will face unrelenting one way pressure until
all margin obligations are met. In fact not only will savvy
market players try to take advantage of the order flow created by the margin
call, but they will often attempt to exacerbate the situation by selling ahead
of the vulnerable trader in order to precipitate even greater selling. Witness
the problems of Long Term Capital Management which found itself in a very
similar situation in 1997 but in the fixed income rather than the energy
market. The fund fell victim not only to its own bad trades but to the
ever deteriorating prices of its positions as bond spreads continued to widen
despite the seeming positive fundamental backdrop as competitors continually
pushed prices lower creating even bigger losses for LTCM.
Seeking
Liquidity in FX
Because of these predatory tactics, hedge funds,
especially large, diversified ones such as Amaranth look to other markets
to raise necessary capital to meet margin calls. With nearly $2 trillion
dollars in average daily turnover the currency market is the most liquid
financial market in the world. As such it offers hedge funds trapped in losing,
illiquid positions in other markets an easy and efficient way to quickly raise
funds and satisfy immediate credit claims. Although it is not completely clear
if Amaranth trades FX directly – the fund utilizes a variety of strategies
without disclosing the exact nature of which instruments it employs - its recent
troubles are unlikely to be an isolated event in financial markets. With
more than 8,000 hedge funds trading every conceivable financial product in the
world often on an extremely leveraged basis, blows ups such as Amaranth’s will
likely become more a rule rather than an exception. As a result these wounded
players will continue to head for the currency market in attempt reliquefy
quickly.
FX – which trades are vulnerable to margin call
liquidation from other markets?
Typically, when multi-strategy
hedge funds head to the currency markets to raise funds they will liquidate
their most profitable positions first. Over the past six months this has
inevitable meant carry trades. For example since its short term bottom on May
17th, USD/JPY with its 500 basis point positive interest rate spread, has
appreciated more than 8% rising from 109 to 118. GBP/CHF – another large carry
trade pair with a 300 basis point positive spread - has risen more than 1000
points or better than 4% over the past 3 months. Finally GBP/JPY which has
climbed more than 1800 points since May of 2006 has also been one of the
biggest gainers of the year. With so much capital gains as well as
carry interest profits booked in these pairs they have become the easiest
targets for profit taking by hedge funds in trouble. Little wonder then that in
the past week all of these pairs appeared to have hit resistance with USD/JPY
trading down from 118.30 to 117.00, GBP/CHF unable to pierce the 236.00 level
and GBP/JPY making a lower double top at 221.00 after reaching a yearly high of
223.72 at the end of August.
While Amaranth’s troubles may yet abate, it
is important to understand that typically forced liquidations are not one day
affairs. LTCM tried to stem the tide of red ink for months before finally
succumbing to a takeover of their positions by a consortium of Wall Street
banks. Therefore, traders looking at opportunities in the FX market will be well
advised to follow the Amaranth saga closely. With Connecticut Attorney General
Richard Blumenthal vowing to investigate the losses and with Amaranth now
raising its loss estimate to $6 Billion from $5 Billion its need to liquefy will
likely continue and its actions may impact the trade flow not only in the energy
markets but in the currency markets as well.