Amaranth Disaster Highlights Independent Pricing

With the saga of Amaranth's blowup unraveled in yesterday's Wall Street Journal story, the wisdom of hedge funds relying on dealers for pricing their derivatives portfolios has come into question. While everyone knows the saga of Amaranth - a hedge fund whose aggressive trader took huge positions in natural gas contracts and then lost $6 billion in one week - there are lessons to learn from this tragedy for other hedge funds and institutions holding volatile derivatives in their portfolios. How about hiring an independent valuation service that is not affiliated with the hedge fund, the investment manager or the prime broker for starters!And Amaranth was trading futures contracts, publicly traded on NYMEX, so the prices were transparent. What about a pension fund that owes money to retirees and is investing in a hedge fund that owns opaque, over-the-counter (OTC) derivatives that are priced according to a dealers' proprietary model.

With OTC derivatives volumes growing, custodians, which represent the pension funds and college endowment plans venturing into alternative investments, need solutions to value derivatives on an independent basis. But there are multiple criteria that should be met to satisfy their needs, says Ed Crouch, global head of corporate and strategic development for SuperDerivatives in New York, which offers SD Revaluation for OTC derivatives.

Two of the hedge funds that had blowups in the commodities sector recently, Amaranth and Mother Rock, evidently had knowledge of all their securities prices. They had all the trade confirms and had all the data on the securities. But they also needed the models. "As time went by, they didn't have a firm grasp of all the values of the entire portfolio," says Crouch. "There is a recognition among the most sophisticated players in the market, that models and data go hand in hand," says Crouch. Second, "having an independent third party who is looking at the value of the portfolio could help the portfolio to be valued more accurately and potentially eliminate these kinds of catastrophic blowups," he adds.

First, they need to pick vendors that can price all the various assets that are being held by them, says Crouch. Second, the valuation service needs to be technologically scalable, notes Crouch. Because the custodians and fund administrators work on volume, they need to have substantial volume capability, he notes. The third piece is accuracy. This has never been an issue in the custodian's historical business of pricing assets for mutual funds and investment managers holding long equities. "When it comes to derivatives, accuracy in pricing is critical," says Crouch. The accuracy comes from obtaining data from active market participants.

In addition to obtaining accurate data, discovering an accurate price requires models, says Crouch. Professional traders use the notion of theoretical value, which is the Black-Scholes options pricing models or a derivative of that model to determine price. However, the price that's actually traded in the marketplace is typically not the theoretical value. It's a market price that's traded, says Crouch. He contends that a difference between SuperDerivatives and other vendors in the marketplace is that "SuperDerivatives faithfully reproduces the price of the interbank dealers," says Crouch. "The interdealer price is the most reasonable price to start with and anything from there is a spread off that price. The price we develop is that interdealer market practice," he says.

Going forward, dealers will keep designing new structures to meet the needs of hedge funds and investment managers. And because the market is constantly changing, users need to pick independent asset pricing vendors that can accommodate new instruments.

Val Heard, SVP of Product Marketing at Numerix, says the software developer is uniquely positioned because its models cover all the traditional asset classes, including credit, foreign exchange, fixed income, cross currency and develops hybrid models, whereas many of its competitors focus on a single asset class. "When that manager is getting ready to move to that new asset class, he doesn't have to make an investment in that technology again," says Heard.

As for what will be the next hot OTC derivative, Heard predicts that the whole hybrid fixed-income/equity market will continue to grow. Derivatives on inflation products, such as inflation bonds, are also starting to pick up.

Meanwhile, SuperDerivatives is planning to enter the credit derivatives market next, says Crouch. "We go into businesses that our customers ask us to be in," says Crouch. "Customers are saying, 'We love your system,' and 'Please bring it to these other asset classes.' What they want is consistency in look and feel and ease of use."

As for the future, Crouch says the next generation of derivatives use is multi-asset derivatives, where there is an interest-rate derivative with an FX component.

For more on this topic, see WS&T's March issue. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio