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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

In 1994 Orange County, California, an investment pool run by its treasurer suffered large losses after interest rates rose sharply. The pool had used reverse repurchase agreements to leverage a portfolio of structured notes. Which feature of the strategy was the principal reason losses became so large?

Leverage was the main reason. Orange County financed longer-dated structured notes with short-term reverse repos, so a rise in rates cut asset values and raised funding costs. The leveraged interest-rate bet magnified losses far beyond what the unleveraged portfolio would have suffered.

  1. ALeverage that magnified the pool's exposure to a rise in short-term interest ratesCorrect
  2. BHeavy use of foreign currency forwards that were unhedged
  3. CConcentrated holdings of equity index futures
  4. DReliance on credit default swaps written on municipal issuers

Explanation

The pool borrowed short-term through reverse repos and bought longer-dated structured notes, so it was effectively a leveraged bet that rates would stay low. When rates rose, asset values fell while funding costs rose and collateral calls followed. The other options describe exposures that were not central to the case.

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