Smith Breeden exemplifies approach to prudent derivatives management.

CHAPEL HILL, N.C.--(BUSINESS WIRE)--Dec. 19, 1994--Recently, several major financial services firms, municipalities in California and Ohio, and Fortune 500 companies suffered significant losses from the speculative use of derivatives.

Many investment industry officials and regulators fear that these highly publicized losses, coupled with concerns regarding the explosive growth of the derivatives market itself, may force limits on the industry's use of derivatives. Derivative limits could impair an investment manager's ability to control risk in portfolios long trusted as relatively safe havens for shorter-term investments.

Last July, Jonathan L. Fiechter, director of the Office of Thrift Supervision (OTS), testified before Congress that OTS considered the regulatory focus on derivative securities "intensive and very healthy." Fiechter testified that these financial instruments serve a vital and useful role in today's markets, but warned that derivatives can be misused. His primary concerns are that derivatives should not be used for speculation by thrifts, and that certain derivatives are extremely complicated and thus potentially misunderstood by investors.

Like Fiechter, Douglas T. Breeden, chairman of Smith Breeden Associates Inc., institutional and retail fund managers of over $15 billion of mortgage securities, believes an appropriate application for fixed-income derivatives is the management of interest rate risk and mortgage prepayment risk. Smith Breeden's successful application of derivatives is demonstrated by The Smith Breeden Short Duration U.S. Government Fund, which Morningstar lists as the number one ARM fund for the one year ending Sept. 30, 1994.

Smith Breeden developed its derivative expertise during the 1980s when the firm pioneered market value risk management for financial institutions. This was during a period of dramatically rising rates and market volatility, which created a need for new tools to better manage interest rate risk. The market responded by creating a host of hedge instruments, now categorized as derivatives. Prior to the 1970s and 1980s, risk was managed by the inefficient and time consuming method of altering a portfolio's mix of assets and liabilities by extending or shortening maturities.

"But today," explains Breeden, "interest rate risk can be managed with more precision and at less cost by using very liquid derivatives such as `plain vanilla' interest rate swaps, interest rate caps and floors and exchange traded interest rate futures. Ultimately there may be more risk in not using derivative instruments than in using them." This is the major reason that Breeden, like many of his mutual fund industry colleagues, is concerned the SEC will enforce its current proposal to cap the level of "illiquid securities," which as defined, includes many highly liquid derivatives such as swaps, caps and floors, at no more than 10 percent of a fund's assets, a drop from 15 percent. Breeden says the focus should not be on a particular type of asset or derivative in isolation, but rather its effect on the overall portfolio or institution holding it. In fact, a derivative which is very volatile or speculative on its own may greatly reduce the risk of an otherwise risky portfolio when used to hedge.

The enormous size of the derivatives market attests to the broad use and acceptance of these instruments. For example, the volume of futures and options on the Chicago Mercantile Exchange (CME) for the month of October 1994 was $14.4 trillion. While representing just a portion of the total derivatives market, this number is more than six times the total amount of Treasury notes and bonds in circulation.

According to Breeden, "there is a full spectrum of fixed-income derivatives available in the markets, ranging from very conservative futures and options on Treasury notes and bonds to the more exotic instruments such as the recently notorious inverse-floating rate bonds. Over the past 12 years, Smith Breeden has developed proprietary quantitative models to assess the potential ongoing effects of many of these derivatives on portfolios, and to gauge their risks." In each of its three fixed-income and equity index mutual funds, Smith Breeden typically utilizes the more liquid, `plain vanilla' derivatives, which explains Breeden, "are less complex instruments than even the typical fixed-rate mortgage loan." The firm's use of these derivatives and superior quantitative analysis have consistently resulted in the Smith Breeden funds generating high returns with less risk than those of competitors.

While some investment firms publicize that they avoid derivatives of all types, Breeden believes that superior track records may be achieved by the prudent use of the more liquid and well understood derivative instruments. "Derivatives are one example of a modern portfolio management tool that can be best applied by professional managers," says Breeden, "and we believe it is wise to provide our clients and shareholders with the benefits of the most current investment research and technology."

Smith Breeden Associates Inc. is an investment grade fixed-income money management and investment advisory firm. The firm is a recognized expert in mortgage-backed securities and applies its own quantitative research, analysis and modeling in managing clients' portfolios. Founded in 1982, Smith Breeden pioneered market value analysis and risk management for financial institutions as well as prepayment analysis for mortgage-backed securities (such as GNMAs, FNMAs and FHLMCs). The firm is a leader in the application of financial and econometric modeling, including option pricing theory. Smith Breeden has consistently translated numerous small advantages in the analysis of fixed-income investments into significant gains for client portfolios. In addition to the Smith Breeden Family of Funds, which serves both institutional and individual investors, Smith Breeden provides discretionary account 

management services for corporate and public pension funds, foundations and endowments. The firm's client list includes Unisys Corp., The Rockefeller Foundation, Eastman Kodak Co., Thomas and Betts Corp., The Investment Fund for Foundations, State of Florida Division of Treasury and New Mexico Public Employees' Retirement Association. With offices in Chapel Hill, N.C.; Overland Park, Kans.; Dallas; and Boulder, Colo., the firm currently employs more than 65 people and provides investment advisory services for over $15 billion of customer assets.

SMITH BREEDEN DERIVATIVES GLOSSARY

Derivative - A derivative is a security whose value is derived from, or based on, an underlying stock, index or reference rate. Many derivatives are highly liquid and used routinely by banks, municipalities and major corporations. However, some derivatives are not very liquid and can be riskier than other types of investments. There are more than 1,000 types of derivatives, of which approximately 300 are frequently used today. The most common include futures, forwards, options and swaps. Interestingly, all of the instruments just listed are actually less complex instruments than the typical fixed-rate mortgage loans.

Interest rate swap -- Generally, an interest rate swap is an agreement between two parties to exchange interest payments of different character (such as the exchange of fixed-rate payments from variable-rate payments). A borrower who has a variable rate loan can use a swap to convert this variable loan into a fixed-rate loan.

Interest rate cap -- An interest rate cap might typically be used to set a ceiling on a variable rate loan. In exchange for a negotiated payment, the cap buyer will receive payments to the extent the loan rate exceeds a specified level. For example, a 7 percent cap pays the holder 1 percent when interest rates are at 8 percent.

Interest rate floor -- An interest rate floor is similar to an interest rate cap, except that the cap buyer receives payments to the extent that the interest rate falls below a specified rate. An interest rate floor might typically be used to fix a minimum rate on a variable rate investment.

Inverse floating-rate bonds -- Inverse floaters are debt instruments whose yield rises when short-term rates fall, and whose yield falls when rates rise. These bonds act very much like long-term bonds and can be very volatile.

CONTACT: Thompson Becker International

Tad Gillespie or Ann Becker, 508/698-0448