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

Orange County's investment pool used reverse repurchase agreements to buy additional structured notes. Which statement best describes the effect of this strategy on the pool's exposure to rising interest rates?

The strategy amplified exposure. Reverse repo borrowing funded additional purchases of long-duration structured notes, so leverage magnified the percentage loss on equity when rates rose, and collateral calls forced losses to be realized.

  1. AIt reduced exposure, because repo borrowing is short term and reprices quickly
  2. BIt had no effect, because the notes were purchased with the borrowed cash at par
  3. CIt amplified exposure, because leverage magnified the loss on long-duration assets when rates roseCorrect
  4. DIt transferred the rate risk to the repo counterparties, who held the securities

Explanation

Borrowing through reverse repos to buy more securities roughly doubled the pool's asset base relative to its equity, so a rate rise produced much larger percentage losses. The repo counterparties held the securities only as collateral and could demand more margin or liquidate, which crystallized the losses.

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