Philippe Jorion’s

Orange County case

Using Value at Risk to Control Financial Risk
History
• Orange County is located in the State of California, USA and it is one of
the wealthiest counties in USA. It had a portfolio of $7.5 billion.
• The County Treasurer Bob Citron delivers returns about 2% higher
than the comparable state pool (California). He was reelected for the
position, despite of repeated public warnings that the pool was too risky
made by John Moorlach, who ran for Treasurer in 1994.
• Intuition: Higher return correlates with higher risk.
• In December 1994, Orange County announces $1.6 billion loss. Shortly
thereafter they declared bankruptcy and liquidated the portfolio.
BOB CITRON’S TRACK RECORD
WHAT WAS BOB CITRON’S STRATEGY?

•Big bet that interest rates would stay constant or

fall
•High leverage, turned $7.5 into $20.5 billion
portfolio
•Used mostly reverse repurchase agreements and
structured notes
How does a reverse
repurchase agreement
work?

• Repurchase agreement (repo, RP):

A contract that stipulates the sale, and later
repurchase, of securities at a particular date
and price. The seller in a repurchase
agreement is typically a securities dealer.
• Reverse repurchase agreement:
The dealer (buyer) trades money for
securities, agreeing to resell them later (Same
* Notice that the trade price is
as a Repo but the roles of the counterpaties
are reversed)
lower than par (Repo Margin)
And structured notes?
• Notes are said to be “structured” when their conditions are
customized to some buyer’s specification
• Payments are not fixed, they are indexed to some financial
variable
• Inverse floater notes:
• As interest rates go up, the coupon paid declines (and
conversely).
• Citron expects the rates to go down, so the coupon increases.
What went wrong with bob citron’s bet?

• On December 1993, short-term yields were less than 3%,

while 5-year yields were around 5.2%
• In February 1994, the Fed started a series of six
consecutive interest rate increases.
• Portfolio Structure (Treasury portfolio V.S Investment
portfolio)
Should it be long or short term investment?
Should it be high or low risk portfolio?
To understand risk, let’s do…
(1) Duration approximation
(2) Computation of VaR
(3) Interpretation of VaR
(1) Duration aproximation
• The effective duration of the pool was reported by the state auditor at
7.4 years in December 1994.
• This high duration is the result of two factors:
 the average duration of individual securities of 2.74 years (most of the
securities had a maturity below 5 years), and
 the leverage of the portfolio, which was 2.7 times.
• In 1994, interest rates went up by about 3%. The portfolio value was
$7.5billion.
• Compute the loss predicted by the duration approximation and
compare your results with the actual loss of $1.64 billion.
cONCEPT CHECK
•The result 7.4 years, is Macaulay
duration or modified duration?
•Do we need Macaulay duration or
modified duration to predict the
approximate loss?
Calculating the predicted loss…
To transform Macaulay to Modified Duration use the
starting 5-year yield at the December 1993 level from the
data file (). Thus, corresponds to 5.22%.
Use the formula for the approximate price change:
(2) COMPUTATION of vAr
• The yields data file contains 5-year yields from 1953 to 1994. Using
this information and the duration approximation, compute the
portfolio VaR as of December 1994. Risk should be measured over a
month at the 95% level. Report the distribution and compute VaR:
- using a normal distribution for yield changes
(Parametric method), and
- using the actual distribution for yield changes
(Historical-Simulation method)
• Compare the VaR obtained using the two methods.
(2a) parametric method
• Calculate monthly returns (r) using the P
duration*
r    D  y
P
approximation:
• Using the data, we get:
 The mean for the monthly return on 5-year Treasury
issues 1ismonth)
VaR(95%, -0.0765%
= [average(r) ] x PortfolioValue
 the standard
0.000765 deviation
1.645 x 0.02838 is 2.8388%
] x $7.5billion

= $0.351billion
(2B) Historical-simulation method
• We have 504 observations. Sort the
returns data from excel file.
• We have to pick the returns0.8such x ( ) + 0.2 x () = 4.63%

that 504x0.05 = 25.2 observations

VaR(95%, 1 month) = r x PortfolioValue
are smaller. So we do interpolation:
95%

0.0463] x $7.5billion

= $0.3471billion
 (3) INTERPRETATION OF VAR
(3.1) Convert the monthly VaR into an annual figure.
Is the latterVaR number consistent with the $1.64 billion
(95%, 1 year) = VaR (95%,1 month) x

Parametric Method
loss?
VaR (95%, 1 year) = $0.351billion x = $1.216billion
Historical Simulation Method
VaR (95%, 1 year) = $0.3471billion x = $1.202billion

Both VaR numbers are smaller than the actual loss

($1.64billion). VaR underestimated the actual loss.
 (3) INTERPRETATION OF VAR
(3.2) After interest rates went up about 3%, in December 1994 the county liquidated the pool and
locked in a loss of $1.64 billion. Then, from December 1994 to December 1995, interest rates fell
from 7.8% to 5.25%. Compute the probability of such an event.
• Basically we are trying to find the probability of a 2.55% decline ( 7.8% - 5.25%). First, we
compute the annual rate change, using the excel data we compute 493 annual rate changes.
• Then, we sort the results obtained from smallest to largest:
• We find that a decline in interest rates of 2.55% or higher happens 23 times out of a total
of 493 times, 4.67%.

• Orange County’s timing was bad; however, at the time very few market observers
expected interest rates to go down so fast in 1995.
 (3) INTERPRETATION OF VAR
(3.3) It seems that both in 1994 and 1995, interest rate swings
were particularly large relative to the historical distribution.
Suggest two interpretations for this observation

• Main interpretation: It has happened before, so it is a normal

market event but with a small probability.
• Secondary interpretation: It happened during the period
when the Fed switched its policy. Whenever the Fed switches
its policy, the market volatility tends to increase.
 Lessons from orange county
• Beware the unconstrained star performer, even if he or she has a long
track record (Supervision)
• Planning and risk oversight mechanisms should be separated
• Borrowing short and investing long means liquidity risk (why?)
• Need for framework of investment policies, risk reporting, and
independent, expert oversight
• Need for comprehensible risk reporting
• If they had used VaR, they would have had a good signal that something is
wrong with the portfolio
• Regulation and transparency is very much needed.
Thanks