Financial Risk Manager Part 1

The primary reason for the scale of losses suffered by the Orange County portfolio in 1994 was the excessive use of leverage. Robert Citron, the treasurer of Orange County, decided to borrow heavily in the repo market. Repos, or repurchase agreements, allow investors to finance a significant portion of their investments with borrowed money, which is known as leverage. However, the use of leverage can have a multiplicative effect on the profit or loss on any position. This means that even a small change in market prices can have a significant impact on the investor. When the Federal Reserve announced an increase in interest rates, the fund could no longer borrow in the repo market at favorable terms and was eventually forced to declare bankruptcy. The excessive use of leverage amplified the impact of the interest rate increase.