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Answer: Banks should match the degree of complexity of trades to the degree of financial sophistication of customers. They should also be cautious about how to use any form of communication.
## Explanation The Orange County bankruptcy case provides several important risk management lessons: - **Option A** is a valid lesson: Robert Citron was considered a "star performer" with a long track record, but his unconstrained investment strategy exposed the county to excessive risk that eventually materialized when interest rates rose. - **Option B** is a valid lesson: The case demonstrates the importance of having proper investment policies, guidelines, risk reporting, and independent oversight to ensure investment actions align with risk-averse objectives. - **Option C** is a valid lesson: Orange County failed to understand the risks inherent in their investment strategy, particularly the risks associated with leverage and complex derivatives like inverse floating-rate notes. - **Option D** is NOT a lesson from the Orange County case: While this is generally good practice in banking, the Orange County case involved a government entity investing its own funds, not banks selling complex products to unsophisticated customers. The key issues were internal risk management failures, not customer protection concerns. The Orange County case primarily highlights failures in internal governance, risk management, and oversight rather than issues related to customer sophistication or communication practices.
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In the early 1990s, Orange County treasurer Robert Citron had managed to borrow $12.9 million through the repo market. The borrowed funds were then used to purchase complex inverse floating-rate notes, whose coupon payments decline when interest rates rise. However, as the Federal Reserve raised interest rates over the course of 1994, the market value of Robert Citron's positions dropped substantially. Eventually, the Orange County was forced to file for bankruptcy. There are several lessons that we have drawn from the Orange County. Which of the following statements is not one of those lessons?
A
Beware the unconstrained star performer, even when he or she has a long track record. Where there is excess reward, there is risk though it might take time to surface.
B
Risk-averse investors must tie investment objectives to investment actions by means of a strict framework of investment policies, guidelines, risk reporting and independent and expert oversight.
C
Firms need to understand the risks that are inherent in their business models, and the leverage need to be used carefully and properly.
D
Banks should match the degree of complexity of trades to the degree of financial sophistication of customers. They should also be cautious about how to use any form of communication.
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