The Hidden Dangers of High Returns
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 â�,�“ 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 Amaranthâ�,��"�s fate underscores the volatile nature of the hedge fund business (in a great example of understatement, SEC Chairman Christopher Cox stated, â�,��"Big losses at Amaranth Advisors LLC demonstrate that investing in hedge funds can be riskyâ�,�) 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. Hunterâ�,��"�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. Hunterâ�,��"�s losses also demonstrates Amaranthâ�,��"�s central problem â�,�“ how to unwind these positions in an orderly fashion?

Forced Liquidation â�,�“ A Nightmare for Some and Opportunity for Others
In a letter to his investors, Mr. Nicholas Maounis, Amaranthâ�,��"�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 â�,�“ 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 Amaranthâ�,��"�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 â�,�“ 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 â�,�“ 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 Amaranthâ�,��"�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.