Financial Risk Manager Part 1

Explanation

In the Orange County case, Robert Citron invested heavily in inverse floating-rate notes expecting interest rates to fall.

Key Points:

• Inverse floating-rate notes are structured products whose coupon payments move inversely to market interest rates
• When interest rates fall, the coupon payments on inverse floaters increase
• Citron's strategy was based on the expectation that interest rates would continue to decline
• However, when the Federal Reserve unexpectedly raised interest rates in 1994, the value of these leveraged positions plummeted, leading to massive losses
• This case demonstrates the dangers of using leverage with complex financial products and making concentrated bets on interest rate direction

The correct answer is B - Citron expected interest rates to fall.