Financial Risk Manager Part 1

Explanation

Both the financial scandals at Bankers Trust and Orange County involved the use of complex financial instruments with an aim to achieve high returns.

Bankers Trust Case:

• Used complex derivatives trades to promise Procter & Gamble (P&G) and Gibson Greetings a high probability of a small reduction in funding costs in exchange for a low-probability, large loss
• These derivatives were intentionally complex to prevent P&G and Gibson Greetings from understanding their risks and overall implications

Orange County Case:

• Treasurer Robert Citron used complex structured products, specifically inverse floating-rate notes, to generate higher than average returns
• These notes' coupon payments would decrease when interest rates rose, effectively betting on interest rates falling or staying low
• When the Federal Reserve increased interest rates, the value of Citron's portfolio decreased significantly, leading to substantial losses

Why Other Options Are Incorrect:

Choice B is incorrect: While both faced significant financial difficulties, they did not collapse as a result of a crippling run. A bank run occurs when customers withdraw deposits simultaneously due to fears of insolvency, but these scandals were primarily related to risky investment strategies rather than mass withdrawals.

Choice C is incorrect: Although Bankers Trust was eventually acquired by Deutsche Bank, Orange County was not dismantled or acquired by another entity after its bankruptcy. Instead, it implemented recovery measures and continues to operate today.

Choice D is incorrect: The statement about heavy investments in mortgage-backed securities is inaccurate. The scandals involved misuse of complex derivatives rather than specific investments in mortgage-backed securities.