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An introduction to municipal derivative products.

Interest rate caps, floors and collars are illustrated and their risks explained in the first part of a two-article series on innovations in municipal capital markets.

During the last few years municipal finance officers have been presented with numerous financing proposals that incorporate the use of municipal derivative products. With the lure of significant interest-cost savings, the proposals urge municipal issuers to augment their staid, "plain-vanilla", fixed-rate borrowings with these new products, whose characteristics generally are unfamiliar to issuers. These products include interest rate swaps, caps, floors and collars, as well as new fixed-rate programs with exotic acronyms, like RIBS/SAVRS, PARS/INFLOS and Bull/Bear Floaters, and partial fixed/partial floating rate products like indexed bonds.

While these products have been used in the corporate and government markets for many years, their use in the municipal market is a relatively recent development. Derivatives may be useful to government finance officials in managing debt and reducing total interest payments. There are risks, however, associated with these products. It is therefore vital that the derivative products, as well as their risks, be well understood by the officials who employ them.

The October 1992 issue of Government Finance Review included two articles on interest rate swaps: an article by Philip N. Shapiro and T. Spencer Wright explaining how swaps work and how an issuer may analyze their usefulness, and a second article by John Haupert describing the use of swaps at the Port Authority of New York and New Jersey. Swaps are but one example of a collection of financing tools referred to as derivative products. The purpose of this article is to introduce and explain some of the other derivative products being used in the municipal market. The first of two installments, the discussion in this issue will focus on interest rates caps, floors and collars. A subsequent article, to be published in the spring, will discuss other derivative products, such as RIBS/SAVRS, PARS/INFLOS, Bull/Bear floaters and partial fixed/partial floating rate products.

What is a Derivative Product?

Derivative products are financial instruments whose own value is "derived" from or based upon the value of other assets or on the level of an interest rate index. For example, the value of a stock option is derived from, among other things, the value of the underlying share of common stock. The values of interest rate swaps, caps, floors and collars are a function of and derived from present and expected future levels of interest rate indexes when compared with a contractual fixed interest rate. The term "derivative products" also refers to financial instruments which have complex structures with option-like features. These features can be embedded in another instrument, such as a call option on a bond, or can be stand-alone in nature, like an interest rate swap. It is possible for financial engineers to build, model and value these complex derivative securities by analyzing them as combinations of simpler underlying securities. In some cases, the use of a derivative allows an issuer to outperform a simpler instrument or structure. The derivatives most frequently used by municipal issuers are swaps, caps, floors, collars and leveraged products, also known as floaters/inverse floaters.

Caps, Floors and Collars

Each of these products have payoff profiles that are dependent upon future, unknown levels of an interest rate index when compared with a contractual, fixed interest rate. With each of these products, a municipality may enter into an agreement which limits its interest-rate risk exposure to variable-rate debt. Use of these products allows risk-averse issuers to use risk sharing to achieve some, if not all, of the benefits offered by variable-rate debt.

There is standard terminology used in connection with these products which is described in great detail in the articles on swaps by Shapiro and Wright and by Haupert in the October issue of Government Finance Review. Readers unfamiliar with the concepts of notional amount, counterparty and interest rate indexes are advised to reference these articles. Briefly, the notional amount is the size of the contract upon which the interest calculations are made, the counterparty is the institution or firm who trades payments with the municipality, and PSA and Kenny are indexes which measure short-term tax-exempt interest rates.

Interest Rate Caps. An interest rate cap is a financial instrument under which payments occur if an interest index (e.g., Kenny) exceeds a certain level, the "Cap Rate." The cap owner makes a one-time, up-front payment to the cap writer and receives an uncertain stream of payments from the cap writer over the term of the cap.

The purpose of a municipal issuer owning a cap in a floating-rate transaction is to ensure that the variable interest rate paid by a municipality will never exceed a predetermined level. The cost of the cap will vary inversely with the interest rate associated with the cap--i.e., a cap of 9 percent would be much less expensive than a cap of 5 percent. In the event that the rate on the Kenny Index rose above the predetermined rate, the counterparty (or the cap writer) would pay to the municipality the difference between the Kenny Index and the cap rate. If the rate is below the pre-determined rate, the counterparty would pay nothing. The formula for the payments for each interest period from the counterparty to the municipality is:

(Notional Amount) x (Period Length) x MAX |(Kenny Index - Cap Rate) or zero~

Assume that a municipal issuer sold $10 million principal amount of variable-rate bonds and that the interest rate on the bonds is equal to the Kenny Index. Assume also that the issuer is risk averse and wants to limit the interest it pays during any period to 5 percent or less for a two-year period. Below is a numerical example of how a cap might work in this situation:

Notional amount: $10 million Cap rate: 5.00% Floating rate index: Kenny Index Term of cap: 2 years Effective date: January 1,1993 Frequency of payments: quarterly beginning April 1, 1993 Up-front fee: paid to counterparty

Exhibits 1 and 2 show the payments made under a cap contract and the net debt service to the municipality for interest rates ranging from 4.00 percent to 5.20 percent. In this case, the municipality limits its net quarterly payment to $137,500 through the use of the cap. In judging the usefulness of a cap, the upfront fee should be compared to the expected present-value payments to be received under the cap.

Interest Rate Floors. An interest rate floor is the opposite of a cap--payments occur if the interest index is less than a certain level, the floor rate. The floor owner makes a one-time, up-front payment to the floor writer and receives an uncertain stream of payments over the term of the floor contract. The municipality issues variable-rate debt and enters into a contract which requires that, if the value of the index goes below a given level, the municipality will make a payment to the counterparty. If the value of the index remains above the predetermined level, the municipality pays nothing to the counterparty. The formula for the payment to be made by the floor writer to the floor owner, or counterparty, is:

(Notional Amount) x (Period Length) x MAX |(Floor Rate - Kenny Index) or zero~

Below is a numerical example of a floor contract:

Notional amount: $10 million Floor rate: 4.50 percent Floating rate index: Kenny Index Term of floor: 2 years Effective date: January 1, 1993 Frequency of payments: quarterly beginning April 1, 1993 Up-front fee: paid to floor writer

Exhibits 3 and 4 describe the payments made under a floor and the net debt service to the municipality assuming that there was a $10 million issuance of floating-rate bonds and the bond rate equalled the Kenny Index. The municipality had to make only one payment under the floor contract in this example because the Kenny Index averaged at least 4.50 percent for all periods except one.

Interest Rate Collars. An interest rate collar is a combination of an interest rate cap and an interest rate floor. Under the terms of a collar, a municipality gives up the potential gain from low interest rates in exchange for protection from high interest rates. The most extreme case of a collar is where the floor and the cap are at the same rate, a fixed-rate bond. In many cases, the cap and floor are selected to offset their costs--i.e., the cost of a collar to the municipality is zero. Under a collar, the counterparty benefits if rates fall, while the municipality benefits if rates rise. Below is a simple numerical example of the use of a collar:

Notional amount: $10 million Cap rate: 5.00% Floor rate: 4.50% Floating rate index: Kenny Index Term of collar: 2 years Effective date: January 1, 1993 Frequency of payments: quarterly beginning April 1, 1993 Up-front payment: None

Exhibits 5 and 6 describe the cash flows associated with this example and the net debt service to the municipality. In this example, the collar is a combination of the cap and floor examples shown above. The municipality has selected a range of variable rates with which it is comfortable and has given up the potential benefit of lower rates in return for protection from higher rates.

Risks Associated with Caps, Floors and Collars. The risks for these derivative products are similar to those for swaps. The major risks include basis risk and counterparty risk. Basis risk is the risk that the issuer's variable-rate debt will diverge from the level of the interest rate index. This could happen in the event the issuer experiences a deterioration in its credit ratings. As described in detail in the articles by Shapiro and Wright and by Haupert, basis risk can add significantly to the costs of variable-rate debt. Counterparty risk is when a counterparty under an interest rate swap, or a cap writer or floor writer, defaults in making payments required under the contract. Should a counterparty default under a cap or collar, the contractual payment will not be received by the municipality, but no principal is at risk. As with a swap, no principal is exchanged with caps, floors or collars. What is lost are any fees paid upfront for the purchase of the cap, floor or collar.


The explosion of "financial engineering" has led to a new generation of financial products. Among them are derivatives securities, which potentially allow municipal issuers, under certain circumstances, to issue debt at reduced interest rates by taking advantage of market opportunities. The following are important caveats when considering the use of a derivative product.

* Understand fully how the derivative works and what the legal obligations of the municipality are under its terms.

* Be fully apprised of the risks of the product--i.e., what could go wrong in the worst case and what the economic impact is.

* Many derivative products require the issuer to make an informed judgment about the future trend in interest rates; issuing officials must have sufficient information and authority to make such a judgment.

* Carefully analyze the debt service costs with and without use of the derivative. Make certain that all relevant costs are included in the analysis and that the options embedded in an instrument are understood (e.g., effective loss of call option during a swap period).

Congressional and Regulatory Scrutiny of Derivative Markets

In Washington, concern about the risks that these complex and highly sophisticated instruments may pose to financial institutions, broker/dealers and their affiliates, and other markets has spread as the market for these products has grown.

The Subcommittee on Telecommunications and Finance of the House of Representatives. Chaired by Representative Edward J. Markey (D-MA), the subcommittee has been tracking the dramatic increase in the trading of new and complex derivative products. Concerned not only that the knowledge of how to oversee the risks associated with these products may not have kept pace with the increase in their use, but for the potential of overall risk to the U.S. financial system as well, the subcommittee has requested the General Accounting Office to conduct a review of the markets, the risk factors and the status of the regulatory activity. Many observers anticipate that the 103rd Congress will undertake an examination of swaps and other derivatives in the coming months and that hearings will be held to evaluate information emerging from numerous studies.

The U.S. General Accounting Office (GAO). The GAO has a study underway to identify the nature and extent of the use of derivative products and to determine how well institutions using derivative products manage the related risk. The GAO has been asked also to determine how well regulators protect the federal interest and to identify any inconsistencies or gaps in regulation among the dealers and users of these products. As part of its information gathering, the GAO is preparing to survey a variety of participants in the capital markets, and the GFOA has been consulted by GAO staff concerning a survey of state and local government users.

The Securities and Exchange Commission (SEC). In July, the Securities and Exchange Commission issued a rule designed to help it estimate the risks involved in the burgeoning derivatives market. The action required holding companies, affiliates and subsidiaries of brokerage firms to report their holdings in quarterly reports filed with the SEC. Broker/dealers were previously subject to this requirement. The rule was extended because derivatives, which are generally traded through holding companies and affiliates rather than through the broker/dealers themselves, had been beyond the scope of the SEC's scrutiny.

The Federal Reserve. The Federal Reserve System's interest in derivatives has had a worldwide cast to it: Fed officials have participated with the Bank for International Settlements, which comprises central bank officials from 10 countries, in a study of the magnitude of derivative activities by financial institutions. The report of the study, released in the fall, documents the dollar volume involved in the rapid growth in derivatives trading.

The Group of Thirty. The Group of Thirty, which includes securities officials, bankers and other financial leaders, has set up a steering committee to study derivative product risks and to possibly develop a guide for managing such risks.
Exhibit 1
 Daily Value Variable-rate Payment by
Date of Index Interest Counterparty
04/01/93 4.00% 100,000 0
07/01/93 4.50 112,500 0
10/01/93 5.00 125,000 0
01/01/94 4.75 118,750 0
04/01/94 5.10 127,500 2,500
07/01/94 5.20 130,000 5,000
10/01/94 4.90 122,500 0
01/01/95 4.85 121,250 0
Exhibit 2
 Income Remarketing Net
 Variable-rate from and Letter of Interest
Date Interest Cap Credit Fees Payment
04/01/93 100,000 0 12,500 112,500
07/01/93 112,500 0 12,500 125,000
10/01/93 125,000 0 12,500 137,500
01/01/94 118,750 0 12,500 131,250
04/01/94 127,500 2,500 12,500 137,500
07/01/94 130,000 5,000 12,500 137,500
10/01/94 122,500 0 12,500 135,000
01/01/95 121,250 0 12,500 133,750
Exhibit 3
 Daily Value Variable-rate Payment by
Date of Index Interest Municipality
04/01/93 4.00% 100,000 12,500
07/01/93 4.50 112,500 0
10/01/93 5.00 125,000 0
01/01/94 4.75 118,750 0
04/01/94 5.10 127,500 0
07/01/94 5.20 130,000 0
10/01/94 4.90 122,500 0
01/01/95 4.85 121,250 0

KATHRYN ENGEBRETSON is the treasurer of the City of Philadelphia and was formerly a vice president in public finance at Lehman Brothers. GARY GRAY is a senior vice president in public finance at Lehman Brothers who specializes in new product development. Continuation of this article is planned for publication in a forthcoming issue of Government Finance Review.
COPYRIGHT 1993 Government Finance Officers Association
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:part II
Author:Engebretson, Kathryn; Gray, Gary
Publication:Government Finance Review
Date:Feb 1, 1993
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