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

Which lesson about risk management is most directly illustrated by the Orange County bankruptcy of 1994?

The key lesson is that risk should be measured on a market-value basis. Orange County's leveraged, long-duration positions hid large mark-to-market exposure to rising rates, and focusing on book returns rather than market value and VaR delayed recognition of the danger.

  1. AReporting performance on a mark-to-market basis would have shown the losses earlier, and risk should be measured using market values rather than book returnsCorrect
  2. BInvestment pools should avoid all fixed-income securities
  3. CHedging with futures always eliminates interest rate risk
  4. DCredit ratings of the issuers were the primary cause of the losses

Explanation

The pool reported results on an accounting basis and relied on stable returns, masking mark-to-market risk from leverage and duration. The losses came from interest rate exposure, not issuer credit, and the lesson is not that fixed income or hedging is inherently wrong.

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