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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.
LIBOR LIBOR Years to "On-the-Run" Indexed Swap Curve BMA/LIBOR BMA Swap Curve Swap Spreads Maturity Treasury Rate (A + B) Percentage (A+B)x C
2 1.64% 0.27% 1. 91% 85 .88% 1.64% 5 2.92% 0.44% 3. 36% 82.50% 2.77% 7 3.34% 0.55% 3.89% 82 .25% :3.20% 10 3.96 % 0.42% 4.38% 82.00% 3.59% 15* 4.18% 0.71% 4.89% 82.00% 4.01% 20* 4.40% 0.71% 5.11% 82.50% 4.22% 30 4.85% 0.35% 5.20% 82.50% 4.29%
* 15 and 20 year treasury rates are interpolated.
20 Floating Index for Interest Rate Swaps
• LIBOR is the standard in the taxable swap market.
• Other common taxable indices include: - Commercial paper - Treasury bills
• Municipal indices: - BMA Municipal Swap Index (formerly PSA index) - J.J. Kenny High Grade Index - Bond rate / cost of funds - Percentage of LIBOR
21 :l !i.^GRI(t L^RF''^3 Like the bond market, the tax-exempt swap market builds in a "risk premium" for future trading relationships
Market Factors • Higher ratios for longer swaps provide additional compensation for risk of change in tax treatment of municipal bonds Ratio (%)
Implied via current market pricing • Actual BMA/LIBOR trading 90% patterns evidence positive technicals of short-term municipal 85% market: 80% - Chronic undersupply of 75% short-term paper (-$200 70% billion money market fund 65% assets and still growing) 60% - "Flight to cash" during 55% market uncertainty - Crossover 50% buyers 1990 1995 2000 2005 2010 2015 2020 2025 Year
22 ssuers must evaluate the credit of the counterparty
The Issuer should be willing to take counterparty exposure to a dealer with natural ratings (no insurance or other forms of credit enhancement) of at least that of the Issuer's
Capitalization
* Ratings Downgrades
Termination
Bankruptcy
23 LURF. . ::V7..^ Agenda
I. 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
24 NVI
e14^•.1 !711 Jx
4l9h' 0
Greater risk = Lower current cost
25 Separating Rate and Funding Decisions
Interest rate swaps allow municipal Issuers to bifurcate interest rate, tax risk and funding decisions in overall debt management strategy...
• Interest rate decision - Floating rate - Fixed rate Synthetic fixed rate structure Fixed rate bonds • Funding decision (Variable rate bonds swapped to fixed) - Committed - Uncommitted Issuer net rate -- 7------exposure • Tax risk decision Synthetic floating rate structure Variable rate - Retain demand bonds - Transfer to investors/dealers (Fixed rate bonds swapped to variable) • Combine risk management T tools with debt issuance Float Committed Uncommitted - Lock- in rate funding funding - Reduce cost of committed funding 1--- Low Issuer risk
26 Swaps can be engineered in variety of ways
0 Swaps can offer a lower cost with more flexibility compared to a natural structure
Synthetic floating rate debt - A client issues fixed rate debt and swaps to floating. CP pays the client a fixed swap rate to offset the outstanding bonds' payments, and in return the client pays CP a floating rate based on a predetermined index
- Synthetic fixed rate debt - A client issues floating rate debt and swaps to fixed. In effect, CP pays the client a floating rate to offset the outstanding bonds' payments, and in return the client pays CP a predetermined fixed swap rate
27 r, svi`^E
^ IAGRICU CRE !,: Interest Rate Swaps Authorized Purpose
Swaps and other interest rate derivatives should be used for legitimate, non- speculative purposes:
Hedging - Swaps may allow the Issuer to better match its assets and liabilities - Swaps may allow the Issuer to hedge interest rate movements
Debt Service Savings - Swaps may allow the Issuer to opportunistically create cheap synthetic variable-rate or fixed-rate debt
28 Interest Rate Swap Benefits
Significant debt service savings, Locks in fixed rate for term of based on historical results financing Can be cheaper alternative to cash Can be cheaper alternative to cash VRDO market fixed -rate bond market Access to variable rates without: Ability to terminate swap for gain if • securing letter of credit interest rates rise • paying remarketing/letter of credit fees • restrictive letter-of-credit bank covenants • risk of failed remarketing/auction • State/Sector-specific remarketing risk Ability to terminate swap for gain if interest rates fall
29 Interest Rate Swap Risks
Credit exposure to swap counterparty - Credit exposure to swap counterparty Exposure to lower floating rates - Exposure to higher floating rates Potential cost if swap is - Potential cost if swap is terminated early terminated early Letter of Credit (LOC) renewal - Potential swap loss from Tax Risk risk/increased credit support if marginal tax rate falls (BMA costs swap) Basis risk between VRDO cost and variable-rate swap index
30 Fixed vs. Floating Rate Levels
Since 1962, floating rate debt has been cheaper 60% of the time "Risk free" U.S. Treasury example
10-yr UST 3- mo UST Spread (bp) Average 800, 147 by Current 3 . 81% 1.19% 2.62% Maximum 791 bp Average 7.36% 6.00% 1.36% Minimum -22 0 Minimum 3.66% 1.15% N/A % Maxmum 15 . 68% 16.75% N/A 650
16.00 500 -1
13.00 350
10.00 200
7.00 50
Breakeven
4.00 -100 -I
1.00 -250 1/5/62 1/5/69 1/5/76 1/5/83 1/5/90 1/5/97 1/5/62 1/5/69 1/5/76 1 /5/83 1 /5/90 1/5/97
1 10-year average of 3-month Treasury Bill is the average of each 3-month Treasury Bill from that day forward for a period of ten years 31 Fixed vs. Floating Rate Levels X77
Since the inception of the modern tax-exempt floating rate market , tax-exempt floating rate debt has consistently outperformed tax-exempt fixed rate debt U.S. Tax-exempt rates: BBI-40 (long term bonds) versus weekly reset rates
BBI-40 TBMA Spread (bp) Average 356 bp Current 5.09 1.52 357.00 Maximum 650 bp Average 6.62 3.92 356.45 Mi ni mum 211 bp Maximum 10.42 8.71 N/A 700 , Minimum 4.86 1.01 N/A 600 -i
500 -I 9.00 r s, Fixed rate: BBI-40 Index 8.00 400 ^
7.00 ^ 300 6.00 200 -I 5.00
4.00 -I 100 -I
3.00 Breakeven 2.00 ^ -100 ii , 1.00 1/4/88 1/4/91 1/4/94 1/4/97 1/4/00 1 /4/ 1985 1/4/1988 1/4/1991 1/4/1994 1/4/1997 1/4/2000 1/4/85
' Roiling BMA is the average of each weekly BMA reset from that day forward 32 'A RICU URF. SM Basic application - synthetic floating rate debt (fixed receiver swap)
0
Synthetic floating rate debt is an alternative to natural floating rate debt
Structure
Mechanism Applications
• The Issuer receives fixed and pays floating • Achieve variable rate exposure without against newly issued or existing fixed rate incurring high support costs bonds • Enhance current yields The Issuer's net cost is BMA +/- the difference between the fixed bond and • Match assets to liabilities swap rates, i.e., cost of liquidity
33 °'C43Fa' S';^^ wb F. Fixed-To-Floating Interest Rate Swaps 't`t' 7796 am
• A fixed-to-floating interest rate swap would allow The Issuer to effectively convert fixed rate debt to synthetic variable (floating) rate debt.
Fixed Swap Rate °rhelssuer
Variable Swap Rate
• The Issuer becomes a "floating rate payer" receiving a fixed rate payment from a counterparty and paying a floating rate based on a pre-determined index. - For new issues, if the fixed rate received by the Issuer equals the fixed rate paid on the bonds, the Issuer's effective cost of funds is the variable rate index. - If, however, the fixed rate swap rate is lower (higher) than the bond rate, then the Issuer effectively pays a spread above (below) the variable rate index.
34 Comparison of floating interest rate costs in the bond and swap markets
Natural floating rate tax-exempt Synthetic tax-exempt floating rate bonds debt
BMA
• Floating rate debt has traditionally • In this example, the Issuer receives been attained through the bond fixed and pays variable in conjunction market with fixed rate bonds
Interest cost Interest cost
Floating rate bond coupon TBMA Fixed rate bond coupon +5.00% Cost of issuance +0.10 Floating payer rate TBMA Remarketing fee +0.10 Cost of issuance +0.10 Bank liquidity/credit fee +0.15 Fixed receiver rate -4.61% All-in cost TBMA + 0.35% All-in cost (net synthetic variable rate) TBMA + 0.49%
35 What drives the synthetic floating rate advantage?
Comparative long term rates - BMA swaps versus tax-exempt bonds
Spot market Spot market (AA)bp MMD minus BMA Index swap rates (bp)' (AA) MMD minus BMA Index swap rates (bp)' 45 -1
Cash floaters attractive
Synthetic floaters attractive -10 5 2 4 10 20 30
1 Mid market rates
36 Cancellation Option (Swaption)
• Cancellation option can be embedded in an interest rate swap to increase the fixed rate received by the Issuer.
• In exchange for paying the higher fixed rate, the Counterparty has the right to cancel the swap at par. - For options embedded in a swap, the premium is normally amortized and paid over the life of the swap in the form of a higher fixed rate. - Option premium can also be taken as an upfront cash payment.
• Counterparty will normally exercise right to cancel swap when interest rates have fallen. 37 Synthetic floating rate wrap-up
Advantages Disadvantages
• No exposure to wider credit spreads • Higher cost than natural floating rate caused by Issuer or LOC bank debt under most market conditions deterioration
• No exposure to increased LOC cost • Swap counterparty credit risk caused by tightening credit enhancement market conditions or Issuer credit deterioration
• No exposure to wider floating rate bond spreads cause by sector shocks • No put risk
• No exposure to remarketing agent performance
• Flexibility to unwind and take market gains
38 ffAGRUCU,t ;URE Synthetic floating rate wrap-up
Rates Decline Rates Rise
• The Issuer can remain in the swap • The Issuer can remain in the swap agreement and receive the existing agreement and receive the existing swap rate. swap rate.
• The Issuer can terminate the swap • The Issuer can terminate the swap and prior to the call date and receive a pay a termination penalty. termination payment. • Short term assets can serve as a • The Issuer can enter into an offsetting natural hedge to floating rate liability. floating-to-fixed rate swap.
• If the Counterparty terminates the Swap on or after the call date, the Issuer could realize savings from a current refunding.
39 Synthetic Floating Rate Swap
Barbeq uevi l le, Tennessee BARBEQUEVILLE , TENNESSEE
Barbequeville, Tennessee (the "City") has outstanding Series 2001 fixed rate debt with an average coupon of approximately 5.00% that matures in 2031.
Through the use of a ten year swap, the City has the opportunity to effectively convert the Series 2001 Bonds from a fixed rate obligation to variable rate debt.
In order to capitalize on current market conditions , the City will lock into a swap based upon the BMA Index that will commence today. The transaction can be implemented quickly using standardized documentation.
The swap will allow the City to obtain funding at the short end of the yield curve, thus better matching its short term assets.
41 BARBEQUEVILLE , TENNESSEE
• Under the swap agreement, the City will pay the counterparty BMA in exchange for the counterparty paying a fixed rate to the City.
• Obtaining floating rate exposure by utilizing the BMA swap market can be more efficient than traditional variable rate debt.
• The City has the flexibility to terminate the swap at any time at market value (the swap counterparty does not have this same right.
• For the term of swap, the City's synthetic floating rate equals: BMA + (Series 2001 Bond Coupon - Fixed Swap Rate)
42 BARBEQUEVILLE, TENNESSEE
Synthetic Floating Rate Structure
,The City has a fixed rate bond issue outstanding. Average bond coupon 5.00% *The City then enters into a swap agreement to Fixed Receiver Swap Rate (4.50%) achieve floating rate exposure. The city will receive a fixed rate of 4.50% and in return pay BMA to the counterparty. Difference -For the term of the swap, the synthetic floating rate will equal BMA + (5.00% - 4.50%), Resulting Variable Rate BMA + 50 bps -The City will achieve lower floating rate debt in comparison to natural floating rate debt.
43 Basic application - synthetic fixed rate debt (fixed payer swap)
Synthetic fixed rate debt is an alternative to natural fixed rate debt
Structure
Fixed rate
Mechanism Applications
• Manage existing variable rate exposure The Issuer receives floating and pays fixed against newly issued or existing floating rate Convert variable rate demand bonds bonds (VRDB's) to fixed
- Net cost of synthetic fixed rate debt = Lock-in future refunding savings fixed swap rate +/- floating rate trading spread + support costs Achieve lower fixed rate debt vs. natural fixed rate Floating-To-Fixed Interest Rate Swap
• A floating-to-fixed interest rate swap would allow the Issuer to effectively convert variable-rate debt obligations (VRDO' s) to synthetic fixed-rate debt.
Variable Swap Rate
Variable Rate
• The Issuer becomes a "fixed-rate payer", making a fixed rate payment to a counterparty and receiving a floating rate based on a pre-determined index. - For new issues , if the variable rate received by the Issuer equals the variable rate paid on the bonds, the Issuer's effective cost of funds is the fixed swap rate. - If, however , the variable rate received is lower ( higher) than the VRDO rate then the Issuer pays an all-in synthetic fixed rate which is above ( below) the swap rate.
45 URFt-^wComparison of fixed interest rate costs in the bond and swap markets
Natural fixed rate tax-exempt Synthetic tax-exempt fixed rate bonds debt
• The traditional method to "lock-in" • In this example the Issuer receives fixed rates has been through the variable and pays fixed in conjunction bond market with variable rate bonds
Interest cost Interest cost
Fixed payer rate 4.71% Fixed rate 5.30% Remarketing and liquidity facility +0.35 Cost of issuance + 0.10 Cost of issuance +0.10 TBMA payment by counterparty -TBMA All-in cost 5.40% Variable rate coupon +TBMA All-in cost (net synthetic fixed rate) 5.16%
46 What drives the synthetic fixed rate advantage?
Comparative long term rates - BMA swaps versus tax-exempt bonds
Spot market Spot market (AA)bp MMD minus BMA Index swap rates (bp)' 90 AAA) MMD minus BMA Index swap rates (bp)' 45 ,
40 ^
35 ^
30-1
25-I
20-1
15 -
10
2 4 10 20 30
' Mid market rates 47 The Issuer can attempt to mitigate "basis risk" through a "cost of funds" swap
Advantages Disadvantages
• The Counterparty (CP) pays the • There is always a cost associated Issuer actual floating bond rate with eliminating this basis risk instead of BMA, eliminating normal market fluctuations • "Cost of funds" generally reverts between the index and the Issuers back to floating rate index (i.e., actual bond rates BMA) in unusual market or credit events (i.e., bond downgrades, taxability of bonds, change in credit facility without consent, etc.)
• Swap becomes less liquid and more expensive to terminate than traditional BMA swap
48 Synthetic fixed rate debt wrap-up
Advantages Disadvantages
• Lower cost than natural fixed rate • Issuer bears all risks associated debt under most market conditions with natural floating rate debt - Credit rollover (can be • Diversification of investor base mitigated through liquidity price protection product) • Lower issuance cost - Basis
• Flexibility to unwind and take • Swap counterparty credit risk market gains • Uncommitted funding
49 Synthetic Fixed Rate Swap
CITY OF VANDY SPRINGS CITY OF VANDY SPRINGS
• The City of Vandy Springs (the "City") needs to finance $10,000,000 in electric system improvements over the next 25 years with the principal wrapped around the City's outstanding debt.
• In today's historically low interest rate environment, the City has the opportunity to lock into attractive rates on this bond issue. However, the swap market currently is providing lower rates than the traditional fixed rate market.
• To capitalize on current market conditions, the use of a fixed rate swap results in gross and present value savings
• Current estimated average coupon on traditional financing is 5.00%. The estimated all-inclusive rate on a fixed rate swap is 4.50%.
51 CITY OF VANDY SPRINGS
The City will issue variable rate bonds and will also enter into a fixed rate swap agreement with a third party . Under the agreement , the City will pay the third party a fixed rate in exchange for the third party paying a variable rate equal to the City's variable rate obligation.
• The transaction can be implemented quickly.
• The fixed swap rate the City will pay the third party is a rate determined in today's low interest rate environment.
52 Nvr
AG ICU . Ci. CITY OF VANDY SPRINGS
Synthetic Fixed Rate Structure
4.10%
-The City issues variable rate bonds Average Coupon on traditional issue 5.00% *The City then enters into a swap agreement to pay Fixed Swap Rate 4.10% a fixed swap rate of 4.10% and receive BMA, offsetting the variable rate obligation. Variable Rate Expenses .40% •A conventional financing results in an average coupon of 5.00%. Debt Service Savings .50% -The City saves .50% over the life of the bond issue or Gross Dollar Savings $949,175 $949,175 in gross savings or $629 , 011 in present value savings compared to a traditional fixed rate Present Value Dollar Savings $629,011 issue.
53 cc r3F S^ Synthetic vs. Natural Structures: The risk/reward tradeoff
• At equilibrium, the party bearing the greatest risk receives the highest reward
Natural Synthetic
Fixed • Higher cost to issuer • Lower cost to issuer - Investor bears most risk - Issuer bears most risk
Floating • Lower cost to issuer • Higher cost to issuer - Issuer bears most risk - Investor bears most risk
• Occasionally, arbitrage opportunities appear that allow an Issuer to either reduce cost and risk or to be overcompensated for the degree of risk taken - Synthetic floating cheaper than natural floating - Synthetic fixed cost advantage overcompensates Issuer for synthetic fixed risks
• Swap market adjusts over time to eliminate arbitrage opportunities - Municipal swap market relatively slow to eliminate arbitrage opportunities 54 Basic Application:
Basis swap where Issuer swaps to another index for different exposure
Mechanism Applications
• The Issuer receives BMA and pays a Issuer wants protection against adverse percentage of LIBOR against newly tax developments issued or existing variable rate bonds Issuer wants better basis matching with The Issuer' s net cost is a floating taxable assets percentage of LIBOR + support costs
55 ssuers can unwind their swaps at market rates
• The Issuer has the flexibility to terminate the swap at any time at market value (the swap Counterparty does not have this same right)
• The swap agreement defines "additional termination events" (i.e., downgrades, defaults, etc.) which would allow either party to terminate the swap at market value
• Termination ("market") value is determined as the present value of the difference between the original and prevailing swap rates discounted at a taxable rate for the remaining term of the swap
• Ask for market quote from Counterparty
• Assign swap to a third party (subject to Counterparty credit approval)
• Enter into offsetting transaction 56 Considerations for Swap Terminations
• Termination of a swap may require the Issuer to make a buyout payment to the swap counterparty
• Potential termination payments can be significant
• A "gain" or "loss" on a swap will normally be offset by a "gain" or "loss" on the underlying bonds being hedged
Termination provisions should be specified in the Schedule • (ISDA Master is "silent" regarding Issuer optional termination) • "Market Quotation" and "Second Method" should be specified in Schedule to the Master Agreement
57 o 1. • 4GR[CUURF' I'a ^• Unwind Methodologies
Issuer enters into a fixed to floating swap at 5%
Issuer decides to terminate the swap: 4 Off-setting transaction would accomplish the Issuer's objective of effectively terminating swap by canceling out swap flows... but Issuer may not find exact offset and would increase its credit exposure
4 The Issuer may have another dealer take its place by assigning the swap...... but CP must approve the new counterparty 4 As a market maker, CP with its extensive book of swaps and high credit ratings, can assure an Issuer of getting the most efficient market quote, or being approved in an assignment
58 An Issuer can terminate its swap with CP at any time with a termination amount based upon "market value"
• "Market value" is determined based on comparing 1) prevailing market rate for a swap with the "mirror image" of the original swap 's economic terms, to 2) the original swap rate
• The market termination value is the present value of the difference in the fixed cash flows of the original and mirror image swaps discounted at LIBOR
;M.^^.• .:^^ ^^.^rigi^nal>swap
Original Swap Mirror Image Swap • Notional : $ 100 million • Notional: $100 million • Issuer pays : BMA • Issuer pays : 4.25% (new market rate) • Issuer receives : 5.00% • Issuer receives : BMA • Maturity : 20-years • Maturity: 15-years
59 Unwinding a fixed-to-floating swap is similar to "fixing-out" a floating rate bond issue
Unwind synthetic Fix-out conventional VRDB's floating rate bonds
• Step 1 : Call the lawyers and notify bank, • Step 1 : Call CP and unwind swap remarketing agent, Issuer and bondholders of - Net fixed value to Issuer equals mode change to a fixed rate mode underlying fixed rate bonds +/- annualized unwind value • Step 2 : Wait 30-45 days and prepare a reoffering disclosure document (Appendix A) • Step 2 : Sign two-page termination confirmation prepared by CP • Step 3 : Secure or reaffirm long term ratings with agencies
• Step 4 : Remarket VRDB's to fixed rate, sell to bondholders and lock in rate - Pay sales commission (i.e., takedown)
• Step 5 : Close remarketing. Pay lawyers, counsel, bankers, etc.
60 Unwinding a fixed-to-floating swap is similar to "fixing-out" a floating rate bond issue (cont'd)
VRDB's Synthetic floating rate structure
• Issue VRDB's when fixed rate alternative = • Issue 5% fixed rate bonds and swap to BMA 5% floating rate index
• Tax-exempt rates increase 300 bp • Tax-exempt rates increase by 300 bp
• Choices • Choices a. Leave VRDB' s outstanding a. Leave synthetic structure in place b. Fix-out with conversion of bonds to fixed b. Unwind 5% swap when market rates = 8% rate - Cost to unwind = PV of 300 bps or lock-in payment of 300 bps/yr to Net result = 8% fixed rate debt swap Counterparty
• Net result Underlying bonds 5.00% + Unwind cost 3.00% All-in cost 8.00%
61 Agenda
I. 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
62 • An option is the right , but not the obligation , to buy or sell a particular asset at a predetermined strike price on or before a predetermined expiration date
• There are three types of options: American options are exercisable at anytime on or before the expiration date E uropean options are exercisable only on the expiration date - Bermu da options (or Multi-European) are exercisable any time on specified dates (i.e., every six months)
• A stri ke is the predetermined exercise price for an option contract. The market price is compared to determine if an asset is "in-the-money" or "out-of-the-money". If the strike price is better than the current market, it is "in-the-money", if it is not as favorable as the current market rate it is "out-of-the-money".
• The expiration date is the predetermined date at which a put or a call must be exercised on or before, depending on the type of the option.
63 The value of the option is composed of time value and intrinsic value
Time value • The value associated with the opportunity for yields to move in a direction that makes the underlying security worth more than the exercise price.
Intrinsic value • The difference between the current forward yield and the strike rate. There is no intrinsic value for an option with a strike rate below the current forward yield.
Strike yield (%)
64 Four key factors primarily determine the value of an option {
• The length of time for which the option is exercisable.
Today Option Underlying This is one of the two components of time value. expires matures
Rate (%) • The market's expectation regarding the future level of interest rates, as derived from the current yield curve. 1 20 30 This determines intrinsic value. Term
Rate (%) 8.0% -k • The fixed coupon for the underlying Hedge Swap or --`- yields 6 .0°/° -- -.------^C Municipal Forwards (i.e., above spot, at spot or below spot) (Spot Price - the price of a swap for immediate 20 30 Term delivery).
• The market's current expectation regarding potential variability in yields. Greater volatility results in higher option value. This also contributes to time value. +/- one S.D. 65 Target Swaption
TITANTOWN , TENNESSEE TITANTOWN, TENNESSEE
• Titantown, Tennessee (the "City") has $50,000,000 Series 1999 bonds outstanding with maturity dates from 2004 to 2029. The average coupon is approximately 5.25%.
• Through the use of a target swap, the City can receive a cash payment today for granting the counterparty the option to enter into a fixed-to-floating rate swap with the City.
• If the option is exercised, the City will receive a fixed swap rate from the counterparty while paying the BMA index.
• If the option expires, the City will keep the up-front payment and maintain the outstanding fixed rate bonds.
67 Counterparty
Up-front Option Premium Payment
• The counterparty will pay the City for the right to direct the City to enter into a synthetic variable rate swap. The counterparty will have this option every quarter for a 2 year period.
• No payments are exchanged unless the option is exercised (except for the up-front payment to the City).
• The fixed rate the City would receive is set at a level more attractive than current fixed receiver rates.
68 ••^rx^F^ s•. •:.,r 2VI
I AGR[CY^tiF. TITANTOWN , TENNESSEE ?96
BMA Index Counterparty Fixed Rate of Fixed Rate 4.50% 5.25% *
Bondholders * Average bond coupon
• The counterparty will exercise the option if swap rates are above the targeted fixed receiver swap rate determined today.
• I he Fxed-to-tloating swap commences with the City receiving the fixed rate from the counterparty and paying the BMA index.
69 TITANTOWN, TENNESSEE
Counterparty City FixJ(e of Fixed Rate 4.50% 5.25% *
* Average bond coupon
• The counterparty will let the option expire if swap rates do not exceed the targeted fixed receiver swap rate.
• If the option expires, the City will keep the up-front payment and its existing bonds remain outstanding.
• The City could choose not to receive an up-front payment today and instead receive a payment at the end of the option period if the option expires unexercised. The payment to the City for this structure could be as much as two times the up-front premium. This payment is only made if the option is not exercised.
70 Depending on the target rate established and the length of the option period, the City can receive a significant up-front payment (and thus savings) for selling this option to the counterparty.
The fixed receiver rate will most likely be set at a level above current fixed receiver swap rates (50 to 100 basis points above current market).
If the option is exercised , the City can achieve BMA funding levels, which historically are very attractive with a 10 year average of 3.22%.
If the option expires , the City will keep the up-front payment and will have the opportunity to pursue other financing alternatives in the marketplace.
71 I. 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
72 Issuers can maintain floating rate exposure and mitigate the effects of rising interest rates through interest rate caps
Caps can be customized to meet Issuer's risk and cost profile
Cap Strategies Description
"Plain-Vanilla " Cap Protection from increases in floating rates above strike price
Collars Protection from increases above a cap but reduction in benefits if rates decline below a floor (offsets cost of cap)
Corridor Protection from increases within a range of interest rates between two strike prices (Less protection than cap, corridor cost can be lowered with collar)
Chooser Caps Protection from interest rate spikes on a retroactive basis
Knockout Caps Protection from increasing interest rates up to a threshold where the cap "knocks out"
73 "Plain vanilla " caps protect an Issuer against interest rates above an established strike rate
Objective: • Protection over a term for increases in interest rates above selected interest rate ("strike rate") Mechanics:
• Issuer pays an upfront premium today for a payout if rates rise above strike rate (premium can also be amortized)
• For each observation, if BMA>strike rate, CP pays Issuer the difference between BMA and the strike rate
• Cost of protection becomes more expensive for lower strike rates and/or longer maturities
Issuer 's floating rate' 4.40 (%)I BMA --®®
1 Does not include annual cost of the cap 74 Collars
Caps and floors can be combined to reduce interest rate volatility at a lower overall cost Objective: • To lock in a range of interest rates; reduce or eliminate cost of cap Mechanics: • Issuer buys 3.9% cap from the Counterparty • Issuer sells 3.7% floor to the Counterparty • Selling the floor (i.e., upside of lower rates) offsets some or all of the cost of the cap • Usually structured on a net cost basis Issuer's cost of funds floats between 3.7% and 3.9%
Issuer 's floating rate (%) CP pays in 4.40 BMA excess of 3.90%
A Buy cap strike
Sell floor strike
Issuer pays difference below 3.70%
Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan
75 Corridors
Caps can be combined to retain benefit of lower interest rates while minimizing effect of interest rates above a specified level Objective: • To hedge against a band of interest rate exposure Mechanics: • Issuer buys 3.90% cap • Issuer sells 4.15% cap • Issuer's cost of funds above 4.15% equals 3.90% plus excess over 4.15% • Sellin g h'i g In st ri e cap red uces tota l cost of low strike cap Issuer can further reduce or eliminate cost of corridor by selling floor
Issuer 's floating rate Issuer pays 3.90% plus excess over 4.15% I
Sell cap strike
3.20 Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan 76 Chooser Caps
Chooser caps provide an Issuer with flexibility to protect against spikes in variable rates Objective: • To hedge against spikes in interest rates on a retroactive basis Mechanics: • A plain vanilla cap provides protection over a finite time period 10 year cap = 40 quarterly caplets A chooser cap provides Issuer with a set number of "caplets" over a given term (e.g. cap 1 0-year contract with 40 quarters; Issuer purchases 10 caplets) Issuer decides in third and fifth - Issuer chooses when to use its caplets quarters whether to use two of its - Choice is made with hindsight and at end of caplet period ten "caplets" to receive a cash benefit equal to shaded regions
Chooser cap strike rate (4.00%)
Small benefit available to Issuer for third quarter
First quarter Second quarter Third quarter Fourth quarter
77 "T f F. S: 00 Y'Vr
: / 4GJ FC URF, Knockout Cap Yi, W,
A Knockout cap allows the Issuer to sell away excess protection above levels deemed unnecessary Objective: • To hedge a range of rates; reducing cost of protection by selling away "excess" protection, while maintaining upside benefit Mechanics: • Issuer buys cap at strike with a knockout feature • Knockout strike set at relatively high level (e.g. 7%) • Cap terminates if BMA averages above knockout strike (7%) for any one quarter • Issuer has protection against reasonable market movement • Rolling quarterly BMA has not risen above 7.25% for any quarter in over 15 years
Issuer 's floating rate (%> After 3 consecutive months above 7%, cap is terminated !Sim Knockout strike
Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan
78 Each interest rate cap alternative offers a trade-off between level of protection and cost
• Entities with floating rate exposure retain the risk that interest rates may rise
• Rising rates increase annual debt service costs, but creates uncertainty in budgeting
79 Each interest rate cap strategy offers a different level of protection ^,779fi"
Type Purpose Cost Risks Flexibility
Plain vanilla cap Insures against rate High None Strike rate can be set increases above a at any rate pre-determined rate
Collar cap To lock in a range of Low Gives up any upside Can be structured interest rates "costless"
Corridor cap To hedge a band of High None Band of interest rates interest rate exposure can be set at any level
Chooser cap To hedge against Medium Protection limited to Issuer can purchase spikes in rates on a number of caplets any number of caplets retroactive basis purchased to be used at any time on a look-back basis
Knockout cap To hedge a range of Medium Cap can be knocked Knockout level can be rates by selling away out, leaving Issuer with set at any level Issuer "excess" protection unhedged floating rate feels comfortable with exposure
80 BMA Cap
TOWN OF GRACELAND TOWN OF GRACELAND
• The Town of Graceland (the "Town") has an outstanding Series 1996 variable rate bond issue but is concerned about rising interest rates.
• While the variable rate bond allows the Town to take advantage of the historically lower rates that variable rate debt can provide, the corresponding risk that interest rates could rise significantly creates the need for tools that provide a degree of protection.
• Thus, it is recommended that the Town utilize an interest rate cap strategy to limit exposure to floating interest rate movements. The BMA cap is an efficient hedge and caps the Town's borrowing cost.
82 TOWN OF GRACELAND
• The Town issued variable rate bonds in 1996.
• The Town will purchase a BMA Cap for the remaining life of the variable rate bond issue at a strike rate of 6%. This strike rate sets the maximum rate the Town will pay.
• Under the agreement, the Town has the choice to pay the cap premium in an up-front payment or over time to the third party.
• The notional amount itself is never exchanged and can be amortizing or a bullet maturity.
• The transaction can be implemented quickly and requires a minimal amount of documentation and time.
83 10%
8%
6% Interest Rate Paid 4% Reference Rate
2%
0% 2% 3% 4% 5% 6% 7% 8% 9% 10% Reference Interest Rate
Transaction: The Town has variable rate debt outstanding and buys a BMA cap with a strike price of 6%.
Result: The curve represented on the dotted line is the maximum interest rate paid during the term of the cap depending on the reference rate.
If on any determination date the current BMA rate is above 6%, the Town will receive a payment from the third party. The Town's net expense is 6%.
If BMA rates stay at or below 6%, then the cap is not utilized. The Town is still out the cap premium.
84 ;IAGRIC[ URF Agenda
I. 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
85 Tf3F,' ,.Or,^ )(V
^ URF.Ii 31 AGR[CUt 1? "^ t J z i What does it mean to hedge an exposure?
Hedging is the process of identifying an exposure and mitigating or eliminating the exposure through an offsetting transaction
Examples of hedges:
Life insurance
Vacation insurance
College Savers Bonds
Rate locks and interest rate caps
86 Hedging process
. Identify exposure(s)
. Determine "risk tolerance" ("deductible")
Identify potential offsetting instruments
Select the type and amount of the most appropriate hedging instruments based on risk tolerance
. Monitor hedge effectiveness H F. -Avr r^\
'(AGR[cU URF Example: Life insurance
Exposure If I die , how will my lost income affect my family?
• College tuition for kids $ 200,000 • Mortgage $ 300,000 • Other ongoing living expenses $ 500,000 $1,000,000
Potential instruments > Life insurance policies, annuity contracts, etc.
Risk tolerance I> Low
Type and quantity I> $1 million life insurance policy of hedge
Ongoing monitoring I> New information - my daughter has an IQ of 180 and receives full scholarship to college!
Action E Decrease policy by $200 , 000 to $800 , 000
88 Evaluating hedge effectiveness - basis risk
Basis risk is the risk that the change in value of the hedged exposure is not well matched by an offsetting change in value of the hedge instrument
Basis risk should be evaluated in determining the most appropriate hedge instrument
Eliminating basis risk may come at additional cost. Consequently, retaining some basis risk may be appropriate if the risk vs. reward trade-off is warranted
89 Basis risk example : Saving for the kids' college education
Assume college costs are projected to increase by 8% per year
Strategy - Buy zero coupon Treasury Bonds that mature in the children's college years to match projected college costs
Basis risk - Increase in college costs may not match 8% assumption
Potential hedge - Buy bonds with a coupon indexed to changes in an index of college costs ("College Savers" bonds)
Cost to eliminate basis risk - May yield less than traditional bonds if college costs go up 8% per year or less
90 Risks affecting Issuers of tax-exempt debt
Issuers may be subject to two risks : adverse market moves that increase cost of capital, and U . S. Treasury market rallies that reduce the rate of earnings on bond proceeds
• Cost of capital risk - Increase in general level of interest rates in advance of issuance 4 Long-term increases in rates due to changes in the economy (e.g., inflation) 4 Short-term increase in rates due to demand/supply imbalances, political uncertainty, economic expectations - Rate increase based on reduced Issuer's credit quality
• Reinvestment risk - During and after the issuance process, rallies in the U.S. Treasury market can significantly reduce earnings on uninvested funds in either a construction fund or in a refunding escrow - Issuers face two distinct risk periods: 4 Between the decision to issue and the sale of the bonds -^ Between the sale and delivery of the bonds
91 Market risks affecting interest rates for Issuers of municipal debt
• Long term interest rate increases result from changes in the economy: - Inflation - Economic growth - Government deficits
• Short term interest rate increases result from: - Supply/demand imbalances - Political uncertainty - Reactions to economic indicators
92 Hedging decision matrix
Interest costs can be fully fixed , partially fixed , or capped prior to completion of the financing through various hedging strategies
Exposure to Hedgin g be hedged Goal alternatives
Lock- in range around today' s rates
93 Each hedging action , or inaction , expresses a market view on interest rates
Directional rate view Issuer's express or implied market
No action - wait 21 Very bullish. Anticipates that interest rates will decrease and transaction is insensitive to adverse market movements
Buy cap/put option Q Somewhat bullish . Anticipates rates may (Rate index cap) decrease but needs protection against significant adverse market movements
Enter into rate collar 2 Slightly bullish . Things may improve a little, but - buy cap and sell floor Issuer needs downside protection if rates move much higher
Lock in forward rates 2 Market neutral to bearish . No strong view on the (Rate lock) `i direction of rates, but transaction is sensitive to market movements
94 U R F. }• -3 'Hedging an exposure
Generally, hedging refers to the mechanisms by which Issuers and investors seek to "neutralize" their financial exposure to changes in interest rates, currency rates , credit exposure, equity prices, and/or commodities prices
• Issuers of tax-exempt bonds retain the risk that interest rates will increase prior to pricing the issue Although current interest rates are at historically low levels, market volatility remains high
• Rising rates erode or eliminate advance refunding savings, but are even more damaging to fixed-rate new money and current refunding issues
• When is hedging a new bond issue appropriate? - Protect refunding savings - Ensure project feasibility - Maximize debt capacity - Inappropriate disclosure periods
• Hedging involves a trade-off between optimizing savings and relative cost
95 The hedging process incorporates several steps
Identify targets PV savings TIC Annual debt service
96 Comparison of hedge types
Comparison of hedge dynamics
Issuer's cost
Fixed cost
e o
Spot Lock Market rate rates
"Locked- in rate" Market determined at X% Set by Issuer at X%
Upfront payment None Market determined
On bond issuance date Cash-settle hedge; Issuer makes or Cash-settle hedge only if receives a payment market rates are greater than strike rate
Result Issuer locks-in a rate today Issuer locks-in a worst- case scenario today, benefits if rates decline
97 Forwards - " cash settle" structure
The purpose of forwards is to lock in a fixed cost today of financing in the future
Hedge value to issuer
Rates move lower loo. Rates move higher
Hedge mechanics
• Issuer and Counterparty agree to "cash settle" a customized forward contract ("rate lock") at or before a given future date, based on a predefined hedge rate
• Hedge rate set by the market
• At bond issuance date, hedge is cash-settled with one of two outcomes: - Market rate > hedge rate - Counterparty pays Issuer PV of difference - Hedge rate > market rate - Issuer pays Counterparty PV of difference
98 t (AGR Hedging entails some residual risks
Risk Definition
Credit risk Change in Issuer 's credit changes Issuer's cost of borrowing
General tax risk Change in tax law affects tax treatment of tax-exempt bonds/swaps
Basis risk Mismatch between hedge's performance and the yield on issuer's refunding bonds
Transaction cost risk Transaction costs impacting hedge savings
Execution risk Artificial and adverse market action due to inefficient execution
Completion risk Non-issuance in conjunction with a decline in rates
99 Additional hedging considerations for Issuers include "credit spread " risk and yield curve "shape" risk
Interest rates Spread vs. index
,li.u :,;.,-v, Yields on Issuer-specific hedge date / trading pattern
Index Yields on delivery date
3 months Term 30 years Credit spread risk is the risk that an . Yield curve shape risk is the risk that the Issuer's own bonds do not trade in a Issuer's amortizing bond structure is left consistent range versus a benchmark exposed to non-parallel rate movements index like the Bond Buyer Index
100 Each hedging index covers a different set of risks
Taxable bonds Taxable swaps Muni swaps Muni bonds Issuer cost of funds (U.S. Treasury) (LIBOR Swap) (BMA Muni (BBI-40/ Swap Index) Delphis Hanover)
101 Agenda
I. 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
102 Hedging Alternatives
Issuers have two primary options for hedging the refunding savings available in the current market
Current Situation Hedging Alternatives Hedging Outcomes ...... Standard fixed-rate bond :...... transaction with a long delivery date Forward delivery Locks-in today's low interest bonds rates Committed funding Cannot be unwound
103 AGRWLI URF - Forward Delivery Bond
Mechanics of forward delivery bond
issuer sets rate and agrees to deliver • Forward bond underwriting is a rending bonds f standard documented fixed rate bond the call date transaction with extended delivery period
• Forward interest rate includes illiquidity premium in addition to the forward premium
Considerations
Eliminates future funding flexibility - Cannot unwind - Cannot receive upfront payment No absolute certainty of closing; reduced level of savings Eliminates opportunity to exploit dynamic bond and swap market relationship High illiquidity premium (depending on delivery date) in addition to forward premium Creates unfavorable disclosure period
104 Fixed Rate Forward Refunding
Opportunity
• Many tax-exempt issuers included call features which allow for the optional refinancing of the bonds on some future dates. The call has an intrinsic value based on the differential between the current rates and the expected future tax-exempt rates on the call date.
• A "Fixed Rate Forward Refunding" allows the Issuer to lock in attractive future rates based on today's low interest rates. In a fixed rate forward refunding, the Counterparty will agree to purchase a new refunding bond issue on the first call date. The new bond coupons will be based on projected forward tax-exempt rates.
Overview
The Fixed Rate Forward Refunding provides an Issuer an opportunity to lock into an attractive savings on its callable debt that cannot be advance refunded.
An Issuer adopts a resolution to issue bonds within ninety days prior to the first call date.
The Issuer enters into an agreement with the Counterparty that establishes the coupons of the new bond issue.
Under the terms of the agreement, the Counterparty has the option not to have the Issuer issue refunding bonds.
If the new bonds are not issued, the Counterparty makes a cash payment to the Issuer on the first call date equal to the present value savings that the new bond issue would have achieved.
If the new bonds are not issued on the first call date, the Issuer retains all rights to call the bonds at any point in the future and keeps the cash payment made on the first call date.
105 Forward Delivery Bond
CITY OF LOOKOUT CITY OF LOOKOUT
• The City of Lookout (the "City") has an outstanding $20,000 ,000 Series 1994 term bond that matures on November 1, 2017 with a coupon of 6.50%.
• The term bond is callable on November 1, 2004 at 102% call price.
• With current interest rate levels near historic lows , a fixed rate forward refunding structure provides the City with an opportunity to refund outstanding bonds and lock in substantial savings beginning on the call date of the bonds.
• The rate on the forward bonds can be determined today.
107 The Counterparty enters into a purchase contract with the City that establishes the issuance of new refunding bonds on the call date. The contract will specify the principal amounts, coupons, and maturity schedule of the refunding bonds
On the call date, the City calls its outstanding debt and sells refunding bonds to the Counterparty on the specified forward settlement date at the purchase price previously agreed upon.
• If the City chooses to receive the savings in an up-front payment, the fixed rate on the bonds will be approximately equal to the coupon payments on the existing bonds leaving its future debt service payments unchanged.
• The transaction can be implemented quickly.
108 u^^jr, yf6^yxr`' fir';( RIC?J SURF. -3 CITY OF LOOKOUT
The City pays the Coupon on the refunding bonds
The Counterparty purchases refunding bonds and pays COI and the call premium
Initial Steps. The purchase contract is signed in which the City agrees to sell bonds to be delivered on the call date to the Counterparty.
Call Date. The City delivers bonds to the Counterparty in exchange for the purchase price agreed upon when the purchase contract was signed. The purchase price includes the call premium and cost of issuance.
Benefit. The City locks into interest savings PV Savings as a % of Notional 5.70% beginning on the call date through the maturity of the refunding bonds. Savings begin on the call date and extend to maturity of bonds.
109 ^;^1.4GRtCU URF. ^^-3 Synthetic Advance Refunding
Opportunity
• A "Synthetic Advance Refunding" allows the Issuer to lock in an attractive refunding rate similar to the Fixed Rate Forward Refunding. In a Synthetic Advance Refunding, the Issuer will commit to issue variable rate refunding bonds on the call date. The Issuer will also enter into a swap agreement with a Counterparty. Under the agreement, the Issuer will pay the Counterparty a fixed rate in exchange for the Counterparty paying a variable rate equal to the Issuers variable rate obligation.
• The swap is executed and the fixed rate portion of the swap is determined on the date of execution (today). However, the exchange of payments does not begin until the call date of the bonds and the issuance of the variable rate bonds.
• In a Synthetic Advance Refunding, the fixed rate on the swap will sometimes be set equal to the coupon on the debt to be refunded, less the remarketing fees and the annual liquidity fee. Therefore, the fixed rate on the swap will be equal to the coupon payments on the existing bonds. This will produce an up front premium payment for the Issuer while leaving its future debt service payments unchanged. The Issuer also has the option to simply lock into a fixed rate which is less than its current debt service requirements.
110 Synthetic Advance Refunding
Mechanics The Issuer will authorize the future issuance of variable rate refunding bonds.
The Counterparty agrees to make variable rate payments beginning on the call date (which offsets the Issuer's variable rate obligation) in exchange for receiving a fixed rate payment from the Issuer.
The up-front premium associated with the Synthetic Advance Refunding can be substantially increased by giving the Counterparty the option to cancel the swap. The Counterparty would only have this option from the execution date to just prior to the call date on the refunded bonds. When this option is combined with a swap, it is called a swaption.
Assuming the transaction is structured correctly, the Issuer should be indifferent between the Synthetic Advance Refunding and the Swaption. The fixed rate that it will be paying within each structure is identical. Under the Synthetic Advance Refunding structure, the Issuer will be paying a fixed rate to the Counterparty that is equal to the coupon rate on its outstanding debt, after factoring in the cost of remarketing and liquidity. Under the swaption structure, payments made by the Issuer will be identical whether or not the swap is cancelled.
If the Counterparty chooses to leave the swap outstanding, the Issuer will pay a fixed rate equal to the coupon rate on its outstanding debt, after factoring in the cost of remarketing and liquidity. If the Counterparty exercises its option to cancel the swap, the Issuer will continue to pay the coupon rate on its outstanding debt. In this situation, the Issuer will also retain its original call option. If interest rates decline in the future, the Issuer could then call its bonds and in effect take advantage of the value of its refunding a second time.
111 r f IAGR[(' U URF, -j z Forward Starting Swaps
Issuers can hedge a future bond issue by executing a forward starting swap in today' s market
Fixed rate swap Final maturity Execute payments Issue variable of swap and forward swap commence . , ,,, ^rate bonds bonds
Today Call Date
Pay old debt service
• By executing a forward starting swap today, Issuer can lock in today's historically low interest rates - Cost of forward hedge = forward rate - spot rate
• While the fixed swap rate is determined today, the actual financing is executed in the future
• A forward starting swap would provide the Issuer with essentially a fixed rate bond issue which is hedged today and closed in the future
• Forward starting swaps can be structured with options
112 Synthetic Advance Refunding
CITY OF ROCKYTOP • The City of Rockytop (the "City") has an outstanding Series 1993 refunding bond issue that can be called on July 1, 2003 at a redemption price of par. The average coupon on the City's 1993 Bonds is 5.50% and cannot be advance refunded.
• In today's historically low interest rate environment, the City has the opportunity to lock into attractive savings on this bond issue that cannot be advanced refunded.
• To capitalize on current market conditions, the use of a forward starting swap effective on the call date is recommended.
• The rate on the swap can be determined today.
114 4GR[Ct^ URF. 1^ - CITY OF ROCKYTOP
• The swap is executed and the fixed swap rate the City will pay is a rate determined in today's low interest rate environment , thereby locking in future savings . However , the exchange of payments does not begin until the call date of the bonds and the issuance of the variable rate bonds.
• On the call date , the City will issue variable rate refunding bonds , and the forward starting swap agreement with a third party will take effect. Under the agreement, the City will pay the third party a fixed rate in exchange for the third party paying a variable rate equal to the City's variable rate obligation.
• If the City chooses to receive the savings in an up-front payment, the fixed rate on the swap will be equal to the coupon payments on the existing bonds leaving its future debt service payments unchanged.
• The transaction can be implemented quickly.
115 CITY OF ROCKYTOP ??9Ci'+r^
Synthetic Advance Refunding Structure
• The City cannot do a conventional refunding. Average Coupon on 1993 issue • The City may enter into a swap agreement to fixed Fixed Swap Rate pay a rate of 4.30% beginning on the call date and receive BMA, offsetting the variable Variable Rate Expenses rate obligation. • The City can receive an up-front payment of the present value savings today or have lower Debt Service Savings annual debt service requirements. PV Savings as a % of Notional • The City issues variable rate refunding bonds on the call date.
116 Application to Refundings
• Forward scale = Spot market scale +Implicit forward premium +Liquidity or additional premium
• Timeline for a Forward Refunding
117 AGRICU URF. "^ Application to New Money
• Rarely, if ever, applied
• Hedge against rising interest rates
• Could be appropriate to project financings
• Generally requires negotiated transaction
118 Application to Refundings
• Useful when bonds cannot be advance refunded - Previously Advance Refunded - Alternative Minimum Tax Bonds - Private Activity Bonds
• Set Settlement Date up to 90 days before date at which the bonds would be currently refundable.
• Capture savings at today's market rates and hedges against rising interest rates
• Capitalize on improved market efficiency
119 tip: c
,i^b(AGR[CU URE -1 Application to Refundings
Forward Scales and Spreads
- 0.40%
- 0.35%
- 0.30%
- 0.25% Vca -Current Scale - 0.20% a) CL Forward Scale - 0.15% -- Spread
0.10%
- 0.05%
"- 0.00% 1 2 3 4 5 7 10 15 20 Years to Maturity
An actual comparison of a 6 month forward refunding issued simultaneous with spot bonds
120 Legislative Issues
• No legislation required - Currently allowed and used - Subject to TCA Title 9, Chapter 21 , Parts 9 and 10
• 1998 Legislation requires - Application to Director of Local Finance - Evidence of Training
121 Regulatory Issues
• Covered by existing regulation by Director of Local Finance - Refundings - Negotiated sales
• New regulations require - Additional disclosures in TCA § 9-21-903 & 1003 plan submittal - Additional disclosures in State Form CT-0253
122 • Forward refundings can be appropriate and responsible
• The Issuer must understand several complex concepts
• Prudence lies within yet undefined parameters
• Expert, independent guidance is most valuable to a forward transaction.
123 i(( . 'AGRiCI 'R F. - Swaps are generally more efficient for longer ll forward transactions
0
Forward premium (bp/year) 160 140 Bonds 120 100 80 Swaps 60 40 20 0 5 years 4 years 3 years 2 years 1 year S pot
Why?
• Less liquidity for forwards in bond market
• Difficult for investors/dealers to hedge forward bond positions
• Forwards contain more credit spread/structure risk for investors
• Limited universe of buyers for cash market forwards
124 Forward starting swaps generally only produce 1.7:1 ,V--11\1 hr savings after the call date
o/ 0 ,Average coupon of 7 refunded bonds C...... 6- Savings realized 57
4-I II-in synthetic fixed rate refunding cost 3-i
2-I
0 Today Call Date Maturity
125 However, Issuers can realize savings tQ.c!.ya by executing a premium swap or swaption
Avg. coupon of refunded bonds
%
Savings realize 5.
4
3
2 Up-front payment to Issuer 1
0 Today Call date Maturity
• By agreeing to pay an all-in rate that is equal to the refunded bond rate, the Issuer will be able to "monetize" the PV of the savings by receiving an up-front payment from the Counterparty
• Savings are present valued at the Counterparty's "cost of funds" rate (Issuer "borrows" at a taxable rate)
• Savings can be enhanced by giving the Counterparty the option to enter into the swap starting on the call date of the underlying bonds
126 The Issuer can enhance the savings currently available by selling an "in-the-money swaption"
• In a swaption , the Issuer sells the Counterparty the right NOT to enter into the swap on the call date
• Since the swaption is currently deep "in-the-money" from the Counterparty's point of view, it is highly unlikely the Counterparty will exercise its option to not enter into the swap on the call date - Rates would have to rise significantly
• In return for this "swaption ," the Counterparty pays an additional up- front fee to the Issuer
• If the Counterparty does not exercise , the Issuer retains up-front payment and still maintains call option on underlying bonds
127 Issuers can use a forward swap structure to hedjc savings available today
The Issuer can either enter into the swap on the call date, or unwind the swap any time and issue fixed rate bonds
Alternative A: Swap Commences Alternative B: Swap Unwound
• Issuer unwinds the swap • Issuer calls bonds • If rates are higher than the fixed swap • Swap commences rate, Issuer receives a cash payment - Issuer pays a fixed rate and • If rates are lower than the fixed swap receives BMA rate, Issuer makes a cash payment • Issuer issues floating rate refunding • Depending on rates, Issuer may or may bonds not refund with fixed rate bonds
128 Forward starting swap considerations
Assuming the swap commences
Advantages Disadvantages
• Hedges highest level of PV • Swap counterparty credit risk savings • Requires issuance of floating rate • Can unwind at any time bonds -- Subject to basis risk between • Can include up front payment fixed cash market and fixed swap market on unwind date • Bond and swap markets can be - Uncommitted funding (credit monitored for opportunities to enhancement renewal risk, terminate the swap agreement for etc.) net gain
129 ^^ rtI3F q^
i(AGR[f' q UURF z rorwara starting swap consiaerations (cont'd)
Assuming the swap does not commence and is unwound
Advantages Disadvantages
• Locks-in highest level of PV • Swap counterparty credit risk savings • May be subject to unwind payment • Fixed rate bonds can be used - Committed funding • Subject to basis risk between fixed cash market and fixed swap market on unwind date
130 AGR1c I URF.l? H Agenda
I. 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
131 ' Documentation
1992 ISDA Standard Master Agreement (Multi-currency vs. Local Currency)
• Master agreement which can govern multiple derivative transactions • Structured as a complete contract containing: - Payment provisions - Representations, events of Default/Termination events and covenants - Early termination provisions and methods for calculating payments on early termination
1992 ISDA D . S. Municipal Counterparty Schedule
Schedule used to make changes to structured provisions - usually negotiated between the two counterparties
Confirmation
Specifies economic terms of relevant transaction (e.g., amortization schedule, interest payment dates, swap rate, etc.) Provides individual modifications to 1992 Agreement Incorporates specific Definitions
132 Schedule to ISDA Master Agreement
The Schedule modifies the boilerplate language in the Master Agreement
The Issuer-elected determinations in Schedule include (but are not limited to):
Section V - Events of Default and Termination Events - Cross Default provision (normally bilateral) - Credit Event upon Merger provision (normally bilatera - Additional Termination Event - Downgrade provision (normally bilateral)
Section XI - Governing Law and Jurisdiction should be clearly defined
Section XII Specified Indebtedness should be narrowly defined
133 ISDA Credit Support Annex
The Credit Support Annex governs the posting of collateral for credit enhancement and should normally be bilateral (two-way collateral)
Majority of modifications to Credit Support Annex made to Paragraph 13, "Election and Variables"
(B) (ii) Eligible Collateral - Definition of collateral that can be posted and any "haircut" - Normally limited to Treasurys and Federal Agencys
(B) (iv) Thresholds - Specifies swap Termination Value threshold by counterparty debt ratings - Should set sufficiently large to minimize "nuisance" collateral transfers while limiting maximum Termination Value exposure
(C) Valuation and Timing ^,. - Sets frequency of collateral mark-to-markets and transfers
(G) Holding and Using Posted Collateral - Defines Custodian (should have minimum 'BBB' long-term debt rating)
134 Legal authorization and due diligence steps
Authorizations - The Issuer must implement proper resolutions which give authorization to execute any derivative transactions
• Obtain enforceability opinion - Opinions from respective counsel that each party can enter into swap transactions and that such contracts are binding and enforceable
Final credit approval obtained from CP - information needed includes: - Most recent audited financial statements - Most recent official statement - Rating agency credit research reports
® Execute ISDA documents
135 fl.^[;R[^1J URF. ^;^ GASB Technical Bulletin No. 2003-1
The objectives and terms of derivative contracts, their risks and the fair value of the contracts are generally not specified in financial reports today, making it difficult to understand how governments have been accounting for derivatives.
In an effort to improve disclosures associated with derivative contracts , the Governmental Accounting Standards Board ( GASB ) has issued Technical Bulletin No. 2003-1, Disclosure Requirements for Derivatives Not Reported at Fair Value on the Statement of Net Assets.
Technical Bulletin No. 2003- 1, which supersedes Technical Bulletin No. 94-1, specifies the accounting guidance that will provide more comprehensive reporting by state and local governments and gives an updated definition of a derivative.
Under the new guidance , the public will be able to see what a government has done, why it was done , the fair value of the derivative and the risks assumed.
This is designed to provide information to increase the financial statement user's understanding of the significance and risks of derivatives to a government' s financial position and would provide key information about the potential effects of derivatives on future cash flows.
136 GASB Technical Bulletin No. 2003-1
The disclosures required by TB 2003-1 are limited to derivatives not reported at fair value. Many derivatives are already reported at fair value. For example, defined benefit plans report all investments (including investment derivatives) at fair value.
Therefore, governments that are party to a derivative that was not reported at fair value as of the date of the financial statements, should disclose the following information:
1) Objective of the derivative: Objective for entering into the derivative, the context needed to understand the objective, and the strategies for achieving the objective. 2) Significant Terms: Notional Amount, underlying indexes, embedded options, effective and maturity dates, and amount of upfront cash paid or received. 3) Associated Debt: For example, if a government issues variable rate debt and enters into a fixed payer swap, the derivative's net cash flow as well as the debt service requirements should be disclosed. 4) Risks: Credit, interest rate, basis, termination, rollover, and market access. 5) Fair value: If the fair value is not based on market prices, the method and assumptions used to estimate the fair value must be disclosed. e This Technical Bulletin will be effective for periods ending after June 15, 2003. The Bulletin may be obtained through the GASB Order Department at 800-748-0659 or may be may be accessed from the website: ( l ).
137 Other disclosure guidance
• GFOA Recommended Practices contain disclosure guidance and discussion of risk in two statements: - Sale of Derivative Instruments by State and Local Governments - Use of Variable Rate Debt Instruments.
• The National Federation of Municipal Analysts released a draft of general obligation debt disclosure guidelines which contain details of appropriate derivative disclosures in debt offerings.
• The AICPA self-study course, Derivatives : Accounting and Auditing Guidance , is an excellent beginning point for understanding derivative transactions while earning 8 hours of CPE.
138 z ;r;RICU URF Hedging and Arbitrage calculations
• The use of swaps or other derivative contracts related to tax-exempt debt may affect the calculation of the arbitrage yield on the bonds.
• The final Arbitrage Regulations published by the IRS in 1993, §1,148, define when a qualified hedge is included in the calculation of arbitrage yield.
• The hedge may change interest rate exposure from either fixed to variable or variable to fixed.
• The hedge contract may have been executed before the issue date of the debt and still be included in arbitrage yield.
139 Agenda
'I. 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
140 ^•P.iiPii P•
^.?C4^:R[CU F. Applicability of Interest Rate and Forward Guidelines *`^. '• ^' 7796
• City and County Debt Obligations (Title 9, Chapter 21)
• Utility District Debt Obligations (Title 7, Chapter 82)
• Public Building Authority Obligations (Title 12, Chapter 10)
• Municipal Utility Revenue Bonds (Title 7, Chapter 34)
• Energy Acquisition Corporation Obligations (Title 7, Chapter 39)
141 :+^.^ 1.4GRIC'1 LRF 7;-T G, ^^ I nterest Rate and Forward G u ideli nes Do Not A I :
• Airport Authorities
• Health, Educational and Housing Facilities Boards
• Industrial Development Boards
142 AA GR ICt F, Statutory Provisions Relating to Interest Rate Agreements
• Permit swaps, floors, ceilings, collars and other hedging agreements
• Agreement must generally be authorized by resolution of governing body
• Prior to adoption of resolution, governing body must receive favorable compliance report from the Comptroller's Office
• Comptroller or his designee must respond within 15 days of request for report
• Agreements may be governed by laws of another state
143 AGR[^U,^'^URh ',-,3 Statutory Provisions Relatin g to Forward
.err 7 >_; Hcyreertierir5
• Permits forward sale agreements from 90 days to 5 years
• Delivery date cannot be later than first call date at par or on which savings can be realized
• Must receive favorable report from the Comptroller's Office prior to entering into forward purchase agreement
144 Procedures for Submitting Request to Enter Into Interest Rate Agreement or Forward Purchase Agreement
• Must be signed by chief executive officer or chief financial officer of governmental entity
Request may not be submitted by underwriters, financial advisers or bond counsel
Comptroller will acknowledge receipt of request for report
• If report is unfavorable, report will identify areas of non-compliance, and governmental entity may resubmit
If report is unfavorable, governmental entity may appeal to State Funding Board
If an agreement is entered into, governmental entity must submit report within 15 days identifying reasons for doing so
If an agreement is terminated, governmental entity must submit report within 15 days identifying reasons for termination and amount of any termination payment
145 Conditions to Entering Into Interest Rate Agreements
• Reduce exposure to changes in interest rate
Manage interest rate risk
• Lower net borrowing cost
• Other
146 / Counterparty for Rate . ^ URF,^ . Requirements interest ,.(.4GR[CJ 1^^ Agreement
• Long-term debt rating of "A" or guaranty from guarantor with an "A" rating
• If no "A" rating, counterparty must collateralize termination value
• Eligible collateral is U.S. government and agency obligations
• Collateral must be held by third-party custodian
• If rating downgraded, collateralization may be required
147 Other Requirements Relating to Interest Rate Agreements
• Interest rate agreement must relate to outstanding debt or debt incurred or authorized contemporaneously with interest rate agreement
• Selection of counterparty can be negotiated or competitive
• ISDA forms should be used
• Governmental entity must be able to identify risks of entering into agreement
• Counterparty must supply monthly market-to-market reports as to termination value
• Must submit information sheet to Comptroller
148 Conditions to Entering Into Forward Purchase Agreements
• Reduce exposure to changes in interest rate risk
• Manage interest rate risk
• Lower net cost of borrowing
• Other
149 Counterparty Requirements for rr: Forward """"" Purchase Agreements
Any party with capital and surplus of at least $10,000,000
• Request to Comptroller must include latest audit of counterparty
150 Other Requirements Relating to Forward Purchase Agreements
• Form of documentation should be similar to bond purchase agreement
• Selection of counterparty can be negotiated or competitive as provided by law
• Governmental entity must be able to identify risks associated with transaction
• Must submit information sheet to Comptroller
151 tip:. jcvr
F I MGR ct uRF, 4 ^ Agenda
I. Introduction
II. Overview of the Derivatives Market and the Role of the Dealer
Ill. 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
152 Swaps are a two sided market intended to benefit users on either side of the market
How swaps originated The first swaps allowed companies to achieve lower financing costs and interest rate exposures than they could otherwise because of comparative advantages in other markets
• Issuer A has A rated credit and can fund more cheaply in the fixed rate market, but wants floating rate funding for a cash asset • Issuer B has B rated credit and can fund more cheaply in the floating rate market, but wants fixed rate funding for a fixed revenue
153
^`rarR `IRF. ; ^, Ti users on either side of the market (cont'd)
How swaps originated
• Issuer A can achieve a fixed rate of Treasury + 0.50% and a floating rate of LIBOR
• Issuer B can achieve a fixed rate of Treasury + 1.50% and a floating rate of LIBOR + 0.50%
Net cost of funds Natural rate synthetic rate Savings Issuer A LIBOR LIBOR - 0.25% 0.25% Issuer B Treasury + 1.50% Treasury + 1.25 0.25% 0.50%
154 AGR[Ct URF. Ii i .[*J The swap market evolved into a dealer market
^,:7Y796; ^_R ^.
Swap dealers now enter into swap transactions as counterparty to the Issuer • Swap dealers became the intermediary designed to match swap counterparties and to remove credit risk Treasury + Treasury + 0.70% 0.80%
Net cost of funds Savings Issuer A LIBOR - 0.20% 0.20% Issuer B Treasury + 1.30% 0.20% Swap intermediary T + 0.70% - (T + 0.80%) 0.10% 0.50%
155 Deriving a taxable swap rate : The easy way
Forget about:
• LIBOR swaps are priced as a spread over Treasuries, much like corporate bonds
• Swap dealers run a simple "bid/offer" business - Receive fixed swap rates at the higher (offer) spread - Pay fixed swap rates at the lower (bid) spread
Maturity Offer rate Bid rate (years) Treasury rate Offer spread (dealer receives ) Bid spread (dealer pays) 3 6.10% 0.18% 6.28% 0.16% 6.26% 5 6.25% 0.22% 6.47% 0.20% 6.45% 10 6.50% 0.25% 6.75% 0.23% 6.73%
156 of ^: qT rx^^,, How market forces determine municipal swap percentages
Case study
• Day one - Market at equilibrium
Maturity Treasury LIBOR LIBOR Muni swap Muni bond Support (years) rate spread swap rate Muni % rate rate costs 10 6.50% 0.25% 6.75% 73% 4.93% 5.40% 0.35%
Fixed Floating Natural 5.40% TBMA + 0.35% Synthetic 4.93% +0.351 = 5.40% -4,93% +TBMA= 5.28% TBMA + 0.47%
Natural fixed more expensive Synthetic floating than synthetic more expensive than natural floating
$500, 000, 000/10 years $500, 000, 000/10 years Fixed (offer) 00
157 How market forces determine municipal swap percentages (cont'd)
Case study
• Day two - Federal tax increase pushes down Tax-Exempt bond rates but leaves Treasury market and LIBOR swap market unchanged - Municipalities, recognizing arbitrage opportunity, enter swap market in force to receive fixed and create synthetic floating rate debt
Maturity Treasury LIBOR LIBOR Muni swap Muni bond Support (years ) rate spread__ swap rate Muni % rate rate costs 10 6.50% 0.25% 6.75% 73% 4.93% 5.25% 0.35%
Fixed Floating
Natural 5.25% TBMA + 0.35% Synthetic 4.93% + 0.35% = 5.25% - 4.93% + TBMA = 5.28% TBMA + 0.32%
Arbitrage opportunity
Synthetic floating less expensive than natural floating
158 :I^`;1.4RECUR\^^^ •^ How market forces determine municipal swap percentages (cont'd) 7796 `;=:
Case study ® Day three - Swap dealers find themselves with an unmatched book due to flood of municipalities receiving fixed
$500, 000, 000/10 years $750, 000, 000/10 years Fixed (offer) Fixed (Bid)
Dealers lower municipal swap percentages to attract synthetic fixed rate business and restore equilibrium and a matched book
Maturity Treasury LIBOR LIBOR Muni swap Muni bond Support (years ) rate spread swap rate Muni % rate rate costs 10 6.50% 0.25% 6.75% 69% 4.66% 5.25% 0.35%
Fixed Floating Natural 5.25% TBMA + 0.35% Synthetic 4.66%+0.35 % = 5.25%-4.66%+TBMA= 5.01% TBMA + 0.59% Large advantage of synthetic fixed will attract issuers
159 Deriving a BMA Index (tax-exempt) swap
• Tax-exempt swap rates are derived by multiplying fixed LIBOR swap rates by market determined municipal swap percentages
• BMA swap dealers also run a simple "bid/offer" business - Receive fixed swap rates at the higher (offer) percentage of the LIBOR swap rate - Pay fixed swap rates at the lower (bid) percentage of the LIBOR swap rate
Maturity (years) Bid (pay) Mid-market Offer (receive) 3 68.00% 69.00% 70.00% 5 73.00% 74.00% 75.00% 10 76.00% 77.50% 79.00%
Example:
Maturity LIBOR LIBOR Dealer (years ) UST yield swap spread swap rate TBMA% Pays fixed 5 5.83% 30 bps 6.13% 73.00% 4.48% Receives fixed 5 5.83% 30 bps 6.13% 75.00% 4.59%
160 How do dealers hedge their transactions?
Each " bundled " structure is broken down and hedged on its base elements
Execution
Hedge
161 LA RI URF. Agenda 4-4-En ..r^a 796
I. Introduction
II. Overview of the Derivatives Market and the Role of the Dealer
III. Fundamentals of the Tax-Exempt Swap Market
IV. Basic Swap Applications
V. Options
VI. Interest Rate Caps
VII. Hedging with Swaps
VIII. Forward Transactions
IX. Legal and Accounting Concepts
X. State Law Requirements
Appendix A - Swap Technicalities
Appendix B - Swap Policy
162 °'^ (;GRI( t RF. l The Issuer's Philosophy Regarding Use of Swaps
._ ' 779$ *`",.•••.
Interest rate swaps are appropriate interest rates management tools. Properly used, swaps can increase the Issuer's financial flexibility and provide opportunities for interest rate savings. Swaps should be integrated into the Issuer's overall debt and investment management policy. Swaps should not be used for speculation.
Swaps are appropriate to use when they achieve a specific financial objective consistent with overall financial policy. Swaps may be used, for example, to lock-in a current market fixed rate or create additional variable rate exposure. Swaps may be used to produce interest rate savings or alter the pattern of debt service payments. Swaps may be used to cap, limit or hedge variable rate payments. Options granting the right to commence or cancel an underlying swap are permitted to the extent the swap itself is otherwise consistent with this policy.
163 .fAGR[ _u URF. -3 The Issuer's Philosophy Regarding Use of Swaps
Rationales for Utilizing Interest Rate Swaps
- Actively manage interest rate risk Lock-in current market rates through (forward starting) floating-to-fixed swap
- Optimize capital structure Sell option to convert variable rate debt to fixed
- Balance financial risk Purchase of interest rate cap
- Achieve appropriate asset/liability match Create variable rate exposure through fixed-to-floating swap
164 Permitted Instruments
Policy
The Issuer may utilize financial instruments which (i) lower its interest expense, (ii) manage its financial risk, or (iii) improve its financial condition.
The Issuer may not use financial instruments which (i) create extraordinary leverage or financial risk, (ii) lack adequate liquidity to terminate at market, or (iii) provide insufficient price transparency to allow reasonable valuation.
The use of derivative financial products should produce a result not otherwise available in the cash market (lack of advance refunding/no callable debt), or provide a higher level of savings.
165 THE ^ 'V1 %41
,IA(';R[CLJ IRF ^ : Perm itted I nstruments ' 796'f
nancial Instruments
The Issuer may expressly utilize the following financial products, after identifying the specific financial objective to be realized and assessing the attendant risks: Interest Rate Swaps • Immediate or forward starting, floating-to-fixed rate swaps, designed to capture current market interest rates. • Fixed-to-floating rate swaps, designed to create additional variable interest rate exposure. Interest Rate Caps • Financial contracts (caps , collars, floors) which limit or bound exposure to interest rate volatility. Options on Swaps • Sale of options to commence or cancel interest rate swaps
166 .'UF'sT NVI r '.^^f?(AR[i'U RF. - Swap Risk Analysis :7. 696,
The Issuer should evaluate all financial products with respect to the unique risks which they bear. A specific determination must be made that the proposed or alleged benefits exceed the identified risks by an adequate margin over those available in the traditional cash market.
At a minimum, the Issuer should perform a risk evaluation of the following factors:
167 Swap Risk Analysis
Risk Evaluation of Derivative F
- Market or interest rate risk Does the transaction hedge or create interest rate volatility?
- Tax Risk Is the transaction subject to a future change in federal income tax policy?
- Termination Risk Under what circumstances might the transaction be terminated? At what value?
- Risk of Uncommitted Funding (Put Risk) Does the transaction create additional financing dependent upon Counterparty participation?
168 Swap Risk Analysis
Risk Evaluation of Derivative Financial Products - continued
- Legal Risk Is transaction expressly authorized?
- Counterparty Risk What is the credit worthiness of the counterparty?
- Rating Agency Risk Is the proposed transaction consistent with current ratings?
- Basis Risk Do the anticipated payments the Issuer receives match the payments it makes?
- Subsequent Business Conditions Does the transaction or its benefits depend upon the continuation, or realization, of specific industry business conditions?
169 Swap Procurement and Execution
The Issuer should not have a fixed policy with respect to swap procurement.
The Issuer should have a bias toward competitively bidding financial products of a general nature which are widely available in the marketplace.
On a product-by-product basis, the Issuer should have the authority to negotiate the procurement of financial instruments which have customized or specific attributes designed on its behalf.
170 Swap Procurement and Execution
Swap Execution
The Issuer's finance committee may recommend the use of financial derivative products if they:
• provide a specific benefit not otherwise available; • produce greater expected interest rate savings than cash market alternatives; • do not create extraordinary leverage or financial risk; • result in an improved capital structure or better asset/liability match; and • reasonably pass the risk evaluation required by this policy.
171 Policy on Swap Counterparties
The Issuer should only do business with highly rated counterparties. The Issuer should structure swap agreements to protect itself from credit deterioration.
172 1H^'8 ° Off, '- 4•..
AC:RICUi URF S. Policy on Swap Counterparties
Guidelines on Counterparty Risk
The Issuer should not have an immutable credit standard. However, the Issuer should attempt to do business with highly rated counterparties of AA or better.
For lower rated (below AA) counterparties, the Issuer should seek credit enhancement in the form of: • Contingent swap counterparty providing a secondary or wrapped obligation; • one-way collateral; • ratings downgrade triggers; and, • Minimum rating threshold of "A", below which mandates assignment.
173 Swap Documentation
The Issuer should use standard ISDA swap documentation including the schedule to the master agreement and a credit support annex.
174 Guidelines on Documentation
The Issuer swap documentation should include the following terms:
• The cross collateral provisions triggering termination should be bilateral.
• The downgrade provisions triggering termination should be bilateral.
• Governing law for swaps will be New York, but should reflect California authorization provisions.
• The specified indebtedness related to credit events in the master agreement should be narrowly drafted and refer only to specific project debt and in no case provide recourse to the members.
• Eligible collateral should be limited to Treasuries and Federal Agencies.
• Collateral thresholds should be set on a sliding scale reflective of credit ratings.
• Termination value should be set by "market quotation" methodology.
• For counterparties below "AA" use a credit support annex to document swap termination value collateralization procedures.
• Include downgrade trigger.
175 Questions and Answers?