Orange county case.docx

Orange county case.docx

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Orangecountycase

PhilippeJorion'sOrangeCountyCase:

UsingValueatRisktoControlFinancialRisk

ThisWebcasecanbeusedbyacademicinstitutionsfreeofcharge;

otherusersshouldcontactProfessorJorion.

Thecaseisalsosubjecttocontinuousimprovements.

©2004-PhilippeJorion

（Downloadedfromhttp:

//www.gsm.uci.edu/~jorion/oc/case.html）

Summary

Thepurposeofthiscaseistoexplainhowamunicipalitycanlose$1.6billioninfinancialmarkets.Thecasealsointroducestheconceptof"ValueatRisk"（VAR）,whichisasimplemethodtoexpresstheriskofaportfolio.Afterthestringofrecentderivativesdisasters,financialinstitutions,end-users,regulators,andcentralbankersarenowturningtoVARasamethodtofosterstabilityinfinancialmarkets.ThecaseillustrateshowVARcouldhavebeenappliedtotheOrangeCountyportfoliotowarninvestorsoftheriskstheywereincurring.

（1）Introduction

InDecember1994,OrangeCountystunnedthemarketsbyannouncingthatitsinvestmentpoolhadsufferedalossof$1.6billion.Thiswasthelargestlosseverrecordedbyalocalgovernmentinvestmentpool,andledtothebankruptcyofthecountyshortlythereafter.

ThislosswastheresultofunsupervisedinvestmentactivityofBobCitron,theCountyTreasurer,whowasentrustedwitha$7.5billionportfoliobelongingtocountyschools,cities,specialdistrictsandthecountyitself.Intimesoffiscalrestraints,Citronwasviewedasawizardwhocouldpainlesslydelivergreaterreturnstoinvestors.Indeed,Citrondeliveredreturnsabout2%higherthanthecomparableStatepool.PlotCitron'strackrecord（Figure1）.

Citronwasabletoincreasereturnsonthepoolbyinvestinginderivativessecuritiesandleveragingtheportfoliotothehilt.ThepoolwasinsuchdemandduetoitstrackrecordthatCitronhadtoturndowninvestmentsbyagenciesoutsideOrangeCounty.Somelocalschooldistrictsandcitiesevenissuedshort-termtaxablenotestoreinvestinthepool（therebyincreasingtheirleverageevenfurther）.Thiswasinspiteofrepeatedpublicwarnings,notablybyJohnMoorlach,whoranforTreasurerin1994,thatthepoolwastoorisky.Unfortunately,hewaswidelyignoredandBobCitronwasre-elected.

Theinvestmentstrategyworkedexcellentlyuntil1994,whentheFedstartedaseriesofinterestratehikesthatcausedseverelossestothepool.Initially,thiswasannouncedasa``paper''loss.Shortlythereafter,thecountydeclaredbankruptcyanddecidedtoliquidatetheportfolio,therebyrealizingthepaperloss.Howcouldthisdisasterhavebeenavoided?

（2）ThePortfolio

Infact,BobCitronwasimplementingabigbetthatinterestrateswouldfallorstaylow.The$7.5billionofinvestorequitywasleveragedintoa$20.5billionportfolio.Throughreverserepurchaseagreements,Citronpledgedhissecuritiesascollateralandreinvestedthecashinnewsecurities,mostly5-yearnotesissuedbygovernment-sponsoredagencies.OnesuchagencyistheFederalNationalMortgageAssociation,affectionatelyknownas``FannieMae''.

Theportfolioleveragemagnifiedtheeffectofmovementsininterestrates.Thisinterestratesensitivityisalsoknownasduration.2.1Defineduration

Thedurationwasfurtheramplifiedbytheuseofstructurednotes.Thesearesecuritieswhosecoupon,insteadofbeingfixed,evolvesaccordingtosomepre-specifiedformula.Thesenotes,alsocalledderivatives,wereinitiallyblamedforthelossbutwereinfactconsistentwiththeoverallstrategy.

Citron'smainpurposewastoincreasecurrentincomebyexploitingthefactthatmedium-termmaturitieshadhigheryieldsthanshort-terminvestments.OnDecember1993,forinstance,short-termyieldswerelessthan3%,while5-yearyieldswerearound5.2%.Withsuchapositivelyslopedtermstructureofinterestrates,thetendencymaybetoincreasethedurationoftheinvestmenttopickupanextrayield.Thisboost,ofcourse,comesattheexpenseofgreaterrisk.PlotthetermstructureonDecember1993（Figure2）.Displaytermstructureofinterestratesasoflastweek:

Bloomberg.

Thestrategyworkedfineaslongasinterestrateswentdown.InFebruary1994,however,theFederalReserveBankstartedaseriesofsixconsecutiveinterestrateincreases,whichledtoabloodbathinthebondmarket.Thelargedurationledtoa$1.6billionloss.PlotthepathofinterestratestoDecember1994（Figure3）.Graphinterestratesoverrecentperiod:

MinneapolisFed.

（3）ValueatRisk

WhatisVAR?

VARisamethodofassessingriskthatusesstandardstatisticaltechniquesroutinelyusedinothertechnicalfields.Formally,

VARisthemaximumlossoveratargethorizonsuchthatthereisalow,prespecifiedprobabilitythattheactuallosswillbelarger.

Basedonfirmscientificfoundations,VARprovidesuserswithasummarymeasureofmarketrisk.Forinstance,abankmightsaythatthedailyVARofitstradingportfoliois$35millionatthe99%confidencelevel.Inotherwords,thereisonlyonechanceinahundred,undernormalmarketconditions,foralossgreaterthan$35milliontooccur.

Thissinglenumbersummarizesthebank'sexposuretomarketriskaswellastheprobabilityofanadversemove.Asimportantly,itmeasuresriskusingthesameunitsasthebank'sbottomline---dollars.Shareholdersandmanagerscanthendecidewhethertheyfeelcomfortablewiththislevelofrisk.Iftheanswerisno,theprocessthatledtothecomputationofVARcanbeusedtodecidewheretotrimrisk.

3.1IntroductiontoVAR

3.2MethodstomeasureVAR

3.3DurationandVAR

NodoubtthisiswhyregulatorsandindustrygroupsarenowadvocatingtheuseofVARsystems.Bankregulators,suchastheBasleCommitteeonBankingSupervision,theU.S.FederalReserve,andregulatorsintheEuropeanUnionsuchasBritain'sFinancialSupervisoryAuthorityhaveconvergedonVARasanacceptableriskmeasure.TheSecuritiesandExchangeCommissionhasissuedanewruletoenhancethedisclosureofmarketrisk.TherulerequirespubliclytradedU.S.corporationtodiscloseinformationaboutderivativesactivityusingaVARmeasureasoneofthreepossiblemethods.

SeethetextoftheEuropeanCapitalAdequacyDirective（98/31/EC）whichallowstheuseofVAR-basedinternalmodels.

OtherSiteswithVARInformation

Perhapsthemostnotableofprivate-sectorinitiativestowardbetterriskmanagementisthatofJ.P.Morgan,whichunveileditsRiskMetricssysteminOctober1994.Forecastsofriskandcorrelationsformorethan400assetsareposteddailyontheRiskMetricssite（nowwithasix-monthlagforfreedata）.TheRiskMetricsdatabaseallowsuserstocomputeaportfolioVARusingtheDelta-Normalmethodbasedona95%confidenceleveloveradailyormonthlyhorizon.

AnotherinterestingsiteisthatofDeutscheBank,whohasacquiredBankersTrustanditsexpertiseinriskmanagement,includingtheRAROC2020system.Thebankprovidesanintegratedapproachtoriskmeasurement,whichisdescribedinitsRiskManagementServicessite.

ThereisagrowingarmyofvendorswhoprovidesoftwarerangingfromExceladd-onstomillion-dollarfirm-wideriskmanagementsystems.Forinstance,visitthesitesofAlgorithmics,BARRARiskManagement,KamakuraCorporation,MisysRiskVision,SungardTradingandRiskSystems.

Amongconsultants,CapitalMarketRiskAdvisorsarewellknown.TheNewYorkconsultingfirmwashiredNovember3,1994,todissecttheOrangeCountyportfolio.Withinaweek,CMRAwarnedthecountythatthepoolhadalreadylost$1.5billion.Thefirmnowspecializesinthevaluationofcomplexportfolios,andin"financialforensics"--analyzingsourcesoffinanciallosses.

Thereisevenanassociationofriskmanagementprofessionals,theGlobalAssociationofRiskProfessionals,whichprovidesaforumfortheexchangeofinformationandeducationintheareaoffinancialriskmanagement.GARPadministersthe"FinancialRiskManager"certificationuponsuccessfulcompletionofanexamination.Forlinkstoriskmanagementsites,visitthefollowingaddress:

BarrySchachter.

Finally,thedebateonVARisheatingup!

Readthe"con"side,advancedbyNassimTalebfollowedbythe"pro"side,advancedbyPhilippeJorion,inarebuttalinDerivativesStrategy,amagazinedevotedtoderivatives.

（4）Questions

LetusplaceourselvesinthepositionofthecountySupervisors,whohadtodecideinDecemberof1994whethertoliquidatetheportfolioormaintainthestrategy（obviously,basedonpastinformationonly）.Atthattime,interestrateswerestillonanupwardpath.AFederalOpenMarketCommitteemeetingwasloomingonDecember20,anditwasfearedthattheFedwouldraiseratesfurther.Toassessthepossibilityoffuturegainsandlosses,VARprovidesasimplemeasureofriskintermsthatanybodycanunderstand--dollars.

（1）Durationapproximation.

Theeffectivedurationofthepoolwasreportedbythestateauditoras7.4yearsinDecember1994.Thishighdurationistheresultoftwofactors:

theaveragedurationofindividualsecuritiesof2.74years（mostofthesecuritieshadamaturitybelow5years）,andtheleverageoftheportfolio,whichwas2.7atthetime.In1994,interestrateswentupbyabout3%.Computethelosspredictedbythedurationapproximationandcompareyourresultwiththeactuallossof$1.64billion.

（2）ComputationofportfolioVAR.

（2）Theyieldsdatafilecontains5-yearyieldsfrom1953to1994.Usingthisinformationandthedurationapproximation,computetheportfolioVARasofDecember1994.Riskshouldbemeasuredoveramonthatthe95%level.ReportthedistributionandcomputetheVAR:

-usinganormaldistributionforyieldchanges（Delta-Normalmethod）,and

-usingtheactualdist