The Orange County investment fund, under the direction of Robert Citron, heavily invested in inverse floating-rate notes. These are complex financial instruments whose coupon payments decrease when interest rates rise. This is in contrast to conventional floating-rate notes, where the coupon payments increase when interest rates rise. The fund’s strategy was based on the expectation that interest rates would remain low or decrease. However, when interest rates rose unexpectedly, the value of the inverse floaters fell dramatically, leading to significant losses for the fund.

Choice A is incorrect. While mortgage-backed securities are indeed complex financial instruments, they were not the primary investment made by Orange County’s investment fund under Robert Citron. The fund primarily invested in inverse floating-rate notes.

Choice B is incorrect. Equities, although a common type of financial instrument, were not the main focus of Orange County’s investment strategy under Robert Citron. The fund was heavily invested in inverse floating-rate notes which are more complex and carry higher risk.

Choice D is incorrect. Credit default swaps are a type of derivative used to hedge against the risk of a debtor defaulting on their loans. However, these were not the specific type of financial instrument that Orange County’s investment fund heavily invested in during Robert Citron’s tenure as treasurer.

Things to Remember

• Leverage in financial markets refers to the use of borrowed funds to increase the potential return of an investment.