What is the difference between a financial explosion and a financial implosion? Was the Amaranth fiasco an explosion or an implosion? Explain
What will be an ideal response?
An implosion hurts only those involved. An explosion hurts those involved and also bystanders. Amaranth was more of an implosion than an explosion because it hurt mainly its own investors, shareholders, and employees. Amaranth met all its margin calls, followed all NYMEX directives, and remained solvent as a result of its purchase by JPM and Citadel. The U.S. Federal Reserve did not get involved in the rescue of Amaranth, and there appeared to be no domestic or international financial disruption or contagion effects. If Amaranth increased natural gas prices (as FERC claims), then consumers may have been hurt. Similarly, if Amaranth increased the volatility of natural gas prices, then many businesses may have hedged early, and as a result, paid more for natural gas than those
that waited and either paid the spot price or locked in futures prices later in the year.
LTCM also was exposed to a high level of model risk because it adopted the risk-management system of Salomon Brothers, which was not sensitive to the particular needs of LTCM and exposures it faced. For instance, Salomon Brothers had a larger variety of independent income sources and better access to liquidity, which could be used to finance positions until they turned profitable. Another part of LTCM's model risk had to do with its focused use of VaR analysis. VaR assumes that the future will be like the past, and market outcomes will follow a normal distribution. Both of these assumptions turned out to be wrong.
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