In: Finance
DISCUSS THE DERIVATIVE STRATEGY THAT WAS RESPONSIBLE FOR THE COLLAPSE OF AMARANTH
The derivative strategy that was responsible for the collapse of Amaranth was the “calendar spread strategy”. This strategy consisted of a single trade of packs that went wrong. Under this strategy more than half of the firm’s AUM (assets under management) was bet on one set of trades. The trader had observed a pattern (based on historical data) with regards to the prices of different natural gas contracts. This was based on the expiration month of the contracts. The trader bet more than 50% of the AUM based on this trend observation. However a not so cold winter (or a mild winter) made the reality quite different from the observed pattern and so the value of the portfolio started nose-diving. The sharp drop made it difficult for the trader to exit the positions. This eventually led to Amaranth’s collapse.
Under the calendar spread strategy the bet that the trader took was that the spread between winter-month natural gas contracts and non-winter-month contracts would increase. However, in reality, instead of widening the contracts shrank. This strategy was an aggressive strategy and eventually it failed.