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In December 1994, the County of Orange in California filed for bankruptcy. This has been the largest municipal failure in U.S. history. The county reported a realized loss of $1.64 billion. Robert Citron, the Treasurer of Orange County managed an investment pool of about $7.5 代写留学生论文billion portfolio which was mainly invested in fixed income securities and structured notes. Additional funding was obtained by issuing Reverse Repurchase Agreements and therefore held a highly leveraged position on the books.

From 1989 to 1992, U.S. interest rates were steadily declining with minor interruptions and therefore the Orange County’s portfolio in fixed income securities gained heavily over those years. Robert Citron was betting on falling interest rates but as interest rates began to rise in February 1994, when the Fed tightened credit (by raising interest rates six times from 3.45% to 7.14%) to reduce the threat of inflation and prevent U.S. economy for overheating, Orange County’s portfolio plummeted. Robert Citron could not keep up with his margin payments on the funds borrowed in the repo market and this, consequently, led to Orange County’s bankruptcy.

The balance sheet of Orange County as of 01 December 1994 looked as follows:
Assets ($) Liabilities ($)
Structured notes (38%)
• Inverse floating-rate notes (26.1%)
• Others (dual index notes (0.7%), floating-rate notes (2.9%), index-amortizing notes (8.3%))

Fixed-income securities (57.7%)

Cash (3.2%)

Collateralized mortgage obligations (1.1%)
5.4 billion

2.4 billion

11.9 billion

0.6 billion

0.2 billion  Liabilities
• Reverse repurchase agreements (63.2%)

 Investor equity (36.8%)

13 billion

7.5 billion

20.5 billion 20.5 billion

Case study questions: (Each question carries equal marks)
1. In December 1994, the average duration of the securities in the portfolio was 2.74 years (since most of the securities had a maturity below 5 years). The portfolio was leveraged by a factor of 2.7. Show that the effective duration of the fund was therefore 7.4 years in December 1994. How and why was the portfolio ‘leveraged’ by a factor of about 2.7?

2. In 1994, interest rates went up by about 3.5%. Compute the loss using the duration approximation and see how this compares with the actual loss of $1.64 billion.

3. The Excel data file attached contains 5-year monthly yields from 1953 to 1994. Measure the volatility of the change in yields in December 1994 (use any simple measure of volatility). Compute the monthly portfolio VaR in December 1994 at the 5% cut off point, using the variance-covariance method. Use Excel to give a histogram of the monthly change in yield (using the whole data set). Using this distribution compute VaR using the Historical-Simulation method. Compare the VaR obtained using the two methods and discuss your findings.

4. Convert each of the monthly VaR figures (from the above two methods) into an annual figure using the ‘root-T’ rule. What assumptions are you making when you use this ‘rule’? Are these assumptions realistic? Is your figure for the annual VaR consistent with the $1.64 billion loss?

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