The orange county bankruptcy was not a derivative related failure. The cause was the pool of investments that the county adopted. The fund had no derivative contracts in it. In its place was structured notes under which the issuer structure the terms to suit the wishes of the investing entity. The county held inverse floaters whose value was often linked, and it is at this point that derivatives come in. A decline in the value of derivatives had an inverse relationship to the value of the floaters, and its holders will earn above market rates. Derivatives caused the failure by allowing the holders of the notes to reap high returns than current market conditions.
Robert Citron was able to earn above-average returns when interest rates fell by understanding the relationship between benefits and return on bonds. He believed that the rate of interest would remain low to enable him to maintain mid-term to long-term papers. A decrease in the rate of interest led to an increase in the value of bonds, and he took this to the structured notes market, and the yields earned by the county were higher than returns on bond mutual funds.
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The board of supervisors was culpable because they allowed Robert to run the County alone without consulting from it. Similarly, their influence in the management od the County affairs was limited especially in earlier years. Exemplary performance by the County attracted many investors who envied Citron and his decisions that relied upon a low-interest regime. The board did not question the single pool of investment for the entire County that was likely to be affected by external factors. The board should have hedged the portfolio of the County to reduce the market risk. They should have relied on expert opinions who raised the alarm concerning the County and discouraged the use of floaters. Finally, they should not allow Robert to be the sole decision maker, and any future investments should be made through consultation.
Credit risk alone is not a sufficient measure of overall portfolio risk and loss potential because other factors affect the riskiness of a portfolio. Risk need to be measured about the market and the volatility of a fund compared to the market. The dispersion of the data and the movement of an investment about its benchmark provide an insight into the overall risk of a portfolio.
Orange County recovered very first after the default by cutting back on social service provision and spending. Citron was charged with six counts of felony, and the charges were basically for misallocation of resources and not for personal gain. In the subsequent years, the county took additional debts in the form of a long-term recovery bond. The debt assisted the County in covering its losses. Increased tax collection from a growing economy helped it to exit from bankruptcy in one and a half year.
The reverse repurchase agreement allowed Citron to use existing securities in the pool that the County had acquired as collateral for additional borrowing. This approach provided an additional cycle of investing that helped the county generate high returns. However, these agreements left Citron vulnerable to calls for extra security whenever the market value of the original collateral fell. In 1994 the level of debt had increased, and the County could not manage its expenditures and increased interest rates. An increase in the rate of interest and the nature of the structured papers led to liquidity problems that eventually resulted in the bankruptcy of Orange County.
An increase in the market risk of Orange County led to liquidity risk and ultimately credit risk. An increase in the rate of interest as a result of the Federal Reserve policy led to a sharp increase in the value of bond and decline in the value of structured papers. The County faced difficulties in paying for the interest of securities. The County could not borrow additional funds to bridge the gap, and therefore it was encountered by a credit risk that eventually led to its bankruptcy.
In agency trading, the risk is transferred to the buyer, not the agent transacting whereas, in proprietary trading, the risk is transferred to the buying financial institution that buys for itself with the aim of acquiring higher returns. In Barings case, the actual loss should have been to the client and a minimal proprietary.
This is a form of a transaction entered by a party to buy or sell a particular asset at an agreed future price and date. Leeson used this approach to increase current profits from unearned revenues.
Net shape of BFS p/l profile after leeson's 1993 swap with Philippe Bonnefoy
The premium paid was equal to the premium received
88888 was an account in the computer purposely set to accept errors. Leeson designated it as client account, but the accounting system recognized it as an error account. It built up a total loss of 208 million pounds in two and a half years. Losses from authorized proprietary trades by the bank were also hidden in the account. Leeson carried out proprietary trading contrary to the bank requirements to cover up losses made in the account.
A cross trade is a practice whereby the trader offsets a buy with a sell of the same stock with no records of the transactions on the exchange. Leeson used this approach to hide the market price of the stock from the clients, therefore, benefiting from higher returns than the market returns.
Leeson took additional risks to escape from the losses made by Baring. He tried to conceal the losses by engaging in more transactions and expanding his position. He was determined to win back the losses by trading harder and taking more risks if the market crumbled.
Leeson took a large speculative position to finance margin requirements. He sold options and borrowed huge amounts from the head office. He also manipulated the trading and accounting records.
Baring's top-up payment was not controlled, and no reconciliation was done. Too much was paid to clients balances to cover the customers' margin calls. The constant amount of top up led to liquidity issues that eventually resulted in the collapse of the bank.
Q uestion 13