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',T4y,H?FS R7e!}^' ?9Iii?[1W::'.4]}Fjf.4:9 iM3^s7',t4Y,H?FS r7E!}^'_?9iii?[1W::'.4]}fJF.4:9",.1Gr^N9'.=dLWStF^^FpBXpIPlw"ie;iflffi{SiR^l :SYl4k^54d'dF :®13(@29s'=.^A"AFt:'^ a SVr AGR[CU l KF. Table of Contents _ !•^s 779$ "i Topic Pages 1. Introduction 2-5 II. Overview of the Derivatives Market and the Role of the Dealer 6-14 III. Fundamentals of the Tax-Exempt Swap Market 15-23 IV. Basic Swap Applications 24-61 V. Options 62-71 VI. Interest Rate Caps 72 - 84 VII. Hedging with Swaps 85 - 101 VIII. Forward Transactions 102 - 130 IX. Legal and Accounting Concepts 131 -139 X. State Law Requirements 140-151 Appendix A - Swap Technicalities 152- 161 Appendix B - Swap Policy 162 - 175 1 Agenda 1. Introduction II. Overview of the Derivatives Market and the Role of the Dealer III. Fundamentals of the Tax-Exempt Swap Market IV. Basic Swap Applications V. Options VI. Interest Rate Caps VII. Hedging with Swaps VIII. Forward Transactions IX. Legal and Accounting Concepts X. State Law Requirements Appendix A - Swap Technicalities Appendix B - Swap Policy 2 What is a derivative? 7-1 Definition • Derivatives, as their name implies, are contracts that are derived from some underlying asset, reference rate or index, including: - Interest rates - Foreign exchange rates - Other fixed income instruments - Commodities - Equity indices Types • Four most common financial derivatives are swaps, forward s, futures and o ptions Forms • Most forms of derivatives are simple and straight forward. Derivative products may become very complex but always use the four basic types as a foundation 3 Policy/ Procedure Requirement Issuers should establish sound monitoring mechanisms for derivative programs The Good... ... the Bad • Lower cost/enhanced savings • Using derivatives to speculate or provide leverage in a speculative • Break down bundled risks into position separately manageable components - Interest rate risk • Executing transactions without proper - Credit risk authorization - Liquidity/put risk - Tax risk • Being sold the "flavor of the day" • Provide greater flexibility • Lack of proper monitoring mechanisms • Manage interest rate exposure • Failing to properly understand potential • Enhance reinvestment yield exposures • Customize solutions to specific problems 4 What is an interest rate swap? An interest rate swap is a contract between two parties to exchange cash flows over a predetermined length of time - Cashflows are calculated based on a fixed or floating rate on a set notional amount - No principal is exchanged Example: • The Counterparty ("CP") and the Issuer agree that: - CP will pay a fixed rate for 5 years on $100,000,000 to the Issuer - Issuer will pay a variable rate for 5 years on $100,000,000 to CP The $100,000,000 is never exchanged and is called the "Notional Amount" The variable index can take a variety of forms including: LIBOR - London Interbank Offering Rate (the rate at which international banks lend to each other) denominated in U.S. dollars (Taxable). See U for a description. B A Index - The Bond Market Association Municipal Swap Index (formerly known as The PSA Municipal Swap Index) (Tax-Exempt). See vvv N,/) nt 111 on and select "Swap Index" for a description. 5 Agenda I. Introduction IIe Overview of the Derivatives Market and the Role of the Dealer III. Fundamentals of the Tax-Exempt Swap Market IV. Basic Swap Applications V. Options VI. Interest Rate Caps VII. Hedging with Swaps VIII. Forward Transactions IX. Legal and Accounting Concepts X. State Law Requirements Appendix A - Swap Technicalities Appendix B - Swap Policy Growth of the Derivatives Market ® Worldwide volatility continues to drive the wider use of privately negotiated derivatives. Contributing factors are: - The convergence of interest rates in Europe in concert with the introduction of the single currency - Continuing Asian financial problems $ trillion outstanding notional amounts (cumulative) 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Figures as reported by the International Swaps and Derivatives Association, Inc.; year end figures Includes interest rate swaps, currency rate swaps & interest rate options (caps, collars, floors, and swaptions) **As of June 30, 2002 7 Swap market participants • As deale rs , banks offer themselves as counterparties to satisfy Issuers' needs for managing financial risk. - Once a position is made, a dealer matches it by entering into an opposing transaction. Derivatives portfolios are managed on a net, or residual risk of their overall position, allowing risk management to be focused on portfolio exposures which improve dealers' ability to accommodate a broad spectrum of Issuers' transactions. • As end u sers , Issuers use derivatives for hedging as part of their asset/liability management while banks use derivatives to take positions as part of their proprietary trading. • By using derivatives products, organizations may also become speculators by taking an unhedged market view or become arb itrageurs by recognizing and acting on a zero-net investment strategy that generates savings or profits. The presence of these participants in the market benefits end users by increasing liquidity. What roles does a dealer fulfill? • Provide market for immediate execution of desired transaction No "match making" required • Able to provide customized rather than "one size fits all" solutions - Unlike standardized futures market • Credit intermediation - No exposure to other end-users • Processing, bookkeeping, billing, and payment calculations - Dealer is responsible for ongoing administration 9 Dealers facilitate a two-sided market Fixed to Floating Rates Floating to Fixed Rates • Dealers earn compensation from bid/offer spreads, not interest rate views 10 Dealers Provide Balance to the Market In a modern market, dealers may temporarily or permanently create surrogates for natural end-users in order to promote liquid two-way markets Dealers manage mismatches in payment dates, credit, indices and maturity on an aggregate, rather than transaction -by-transaction basis Daily Transactions Activity with End- users (example) dui 11 What is ISDA? • The International Swaps and Derivatives Association (ISDA) is the leading global trade association representing participants in the privately negotiated derivatives industry. The business includes: - Interest rate , currency, commodity and equity swaps - Related products such as caps, collars, floors and swaptions Members • ISDA has over 5751 members from around the world including the world's major institutions who deal in, or are leading end- users of, privately negotiated derivatives Purpose • ISDA was established in 1985 to - Develop and maintain standard documentation for derivatives - Foster high standards of commercial ethics and business conduct - Advance international public understanding of derivatives - ISDA's web site is www.ISDA.org 1 As of December 2002 12 +(AC;RWU URF.1-3 Documentation Swap products should be documented using standardized documentation. • International Swaps and Derivatives Association (ISDA) - Master Agreement - Schedule to the Master Agreement - Confirmation (normally executed within 48 hours of the trade date) - Credit Support Annex • Documentation should be reviewed by legal counsel and advisors. • Swap counterparties often require a legal opinion or other certifications stating that Issuer has the legal authority to enter into a swap. 13 Key Terms of Interest Rate Swaps and Caps • Notional principal amount • Effective date • Termination (Maturity) date • Fixed Rate Paid (Received) • Strike Price (Caps only) • Floating index, e.g. LIBOR, BMA • Index Reset Frequency, e.g. 1-month, 3-month • Payment dates (payments normally made in arrears) • Day basis (e.g. 30/360, Actual/365) 14 ;RIC_U URF. ^T L ipC Agenda I. Introduction II. Overview of the Derivatives Market and the Role of the Dealer lll. Fundamentals of the Tax-Exempt Swap Market IV. Basic Swap Applications V. Options VI. Interest Rate Caps VII. Hedging with Swaps VIII. Forward Transactions IX. Legal and Accounting Concepts X. State Law Requirements Appendix A - Swap Technicalities Appendix B - Swap Policy 15 Swap Products Procurement • Tax law does not require competitive bidding • Traditionally done on a negotiated basis • Competitive bidding has become much more common as swaps usage increases in the municipal market • Factors that influence procurement method - Complexity of transaction - Credit of Issuer - Size of transaction • The Issuer should not be locked into a specified procurement methodology 16 The BMA Municipal Swap Index is the principal synthetic floating rate benchmark for municipal Issuers The BMA Municipal Swap Index ("BMA Index", formerly PSA) is an average of typically 250 active high-grade, tax-exempt, variable rate programs with weekly interest rate resets The BMA Index is calculated independently by Municipal Market Data, under the sponsorship of The Bond Market Association • Since 1990, the BMA Index has been accepted as the market benchmark for short-term, tax- exempt rates, replacing the J.J. Kenny High-Grade Index 1990 to date 3.39% Last 10 years 3.10% Last 5 years 2.97% I Year to date 1.38% 0 ' 1/3/1990 1/3/1992 1/3/1994 1/3/1996 1 /3/1998 1/3/2000 1/3/2002 17 TBMA versus LIBOR (as of December 2002) The tax-exempt swap yield curve (TBMA) is steeper than the taxable swap yield curve (LIBOR) 6.00% 100% Spot Short 30-year Rate Rate Steepness 5.50% 90`; LIBOR 1.38% 5.08% 3.70% 5 .0 0% BMA 1.52% 4.13% 2.61% 4.50% 60%, (B) BMA Swap Percentages 4.00% a0 (A) LIBOR Swap Rates a 3.50% a Fixed receiver a 3.00% a ratio (%) a 0 84.50% 2.50% 0 81.75% 0 2.00% 78.88% (A) BMA Swap Rates 79.00% 1.50% 79.00% 1.00% 30 `, 81.30% 1 3 5 10 20 Spot 110.14% 18 \c;RICU ti lzl: TBMA versus LIBOR (as of November 1999) The tax-exempt swap yield curve (TBMA) is steeper than the taxable swap yield curve (LIBOR) 7.00% Spot Short 30-year Rate Rate Steepness (A) LIBOR Swap Rates 6.50% LIBOR 6.07% 6.93% 0.86% BMA 3.34% 5.35% 2.01% 6.00% (B) BMA Swap Percentages 5.50% Fixed receiver 5.00% ratio (%) 64.13% (A) = BMA Swap Rates 4.50% -I 65.75% 68.13% 4.00% -I 70.13% 72.63% 77.88% 3.50% I I Spot 0 5 10 15 20 25 30 55.02% 19 How to Build the BMA Swap Curve • The BMA swap curve is derived from the LIBOR swap curve.
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