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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: **Correct Lessons from Orange County:** - **Option A** is correct - Robert Citron was considered a star performer with a long track record, but his unconstrained investment approach eventually led to massive losses when interest rates rose. - **Option B** is correct - The case highlights the need for proper investment policies, risk reporting, and independent oversight to prevent excessive risk-taking. - **Option C** is correct - Orange County failed to understand the risks in their investment strategy, particularly the leverage through repo markets and the sensitivity of inverse floaters to rising rates. **Why Option D is NOT a lesson from Orange County:** - The Orange County case involved a government entity (not a bank) making investments for its own portfolio, not selling complex products to customers. - The key issues were about internal risk management, leverage, and interest rate exposure, not about matching product complexity to customer sophistication. - The communication aspect mentioned in Option D relates more to cases like the Procter & Gamble derivatives lawsuit, not the Orange County bankruptcy. The Orange County case primarily teaches lessons about internal governance, risk management frameworks, and the dangers of excessive leverage in public sector investing.
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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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