UNIVERSITY OF COLORADOBOULDER

Prepared by:

P. Jonathan

Heroux

Managing

Director

April 14, 2005

Derivatives in the Municipal Market Place

Presentation to:

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Presentation Outline

• Municipal Finance Overview

Fixed Rate Obligations

Variable Rate Obligations

• Municipal Derivatives

Interest Rate Swaps

Swap Options (Swaptions)

Knockout Swaps

Forward Delivery Contracts

Interest Rate Locks

Caps, Floors and Collars

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Size of Market Over $1.5 Trillion in tax-exempt debt outstanding In 2004 there were 13,400 new issues totaling

over $360 Billion

Diverse Issuers State and Local Governments Government Agencies K-12, Higher Ed.

Diverse Projects Airports Hospitals Water Systems Housing Urban Renewal

Municipal Finance Overview

State Authorities

29%

Municipalities38%

Colleges & Universities

2%

State Governments

13%

Other2%

Local Authorities

16%

Issuers of Municipal Bonds

2004 By Par Issued

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Fixed Rate Obligations

Bonds are issued as Serial or Term bonds. Serial Bonds:

Most common fixed rate bonds. Serial bonds pay a stated fixed interest and principal

payment at regular intervals (one principal payment per year).

Each separate maturity has a distinct and stated interest rate.

Allow issuer to borrow across the yield curve.

Example of a Serial Bond:

Fixed Rate Bonds

MaturityType of Bond Coupon Yield

Maturity Value Price Dollar Price

12/01/2005 Serial Coupon 3.000% 1.500% 3,090,000.00 101.483% 3,135,824.7012/01/2006 Serial Coupon 3.000% 2.000% 3,185,000.00 101.950% 3,247,107.5012/01/2007 Serial Coupon 3.000% 2.500% 3,280,000.00 101.436% 3,327,100.8012/01/2008 Serial Coupon 3.000% 3.000% 3,380,000.00 100.000% 3,380,000.0012/01/2009 Serial Coupon 3.000% 3.500% 3,480,000.00 97.724% 3,400,795.2012/01/2010 Serial Coupon 3.000% 4.000% 3,585,000.00 94.712% 3,395,425.20

Total - - - $20,000,000.00 - $19,886,253.40

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Fixed Rate Obligations (cont.)

Bonds are issued as Serial or Term bonds. Term Bonds:

Term may extend for any period, typically 2 to 25 years. Principal paid at maturity. Term bonds have one interest rate for the entire term.

Example of a Term Bond:

Fixed Rate Bonds

MaturityType of Bond Coupon Yield

Maturity Value Price Dollar Price

12/01/2015 Term 3.000% 4.500% 20,000,000.00 87.097% 17,419,400.00

Total - - - $20,000,000.00 - $17,419,400.00

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Variable Rate Obligations

Variable rate bonds have “floating” interest rates.

The interest rate on the bonds is reset to current market rates at predetermined time intervals.

The periodic reset of interest rates allows the issuer to borrow at the short end of the yield curve, thus initially lowering the cost of debt.

One unique feature of variable rate bonds is that investors are able to sell back, or “put” their bonds to the remarketing agent when the rates are reset.

Issuer must purchase a Letter of Credit from a bank. The LOC provides liquidity for the bonds.

Example savings: If an issuer can lower the interest rate by 10 bps on a $20MM 20 year loan, it will save over $260,000 in total interest costs.

Variable Rate Demand Obligations (VRDO’s)

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Interest Rate Comparison

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

Mar-95 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05

Yie

ld

Bond Buyer's G.O. Index Bond Buyer's Rev. Index BMA Municipal Swap Index

Fixed vs Variable Interest RatesLast 10-Years

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Size and Swap Providers:

Current size approximately $150 Billion in notional amount.

Some major Swap providers are:J.P. Morgan, Bank of America, Morgan Stanley, Merrill Lynch, Piper Jaffray, Citigroup, Goldman Sachs

Who Uses Swaps and Financial Derivatives:

501(C)3 non-profits (hospitals, private colleges, YMCA’s, Museums/ performing arts).

Public universities. Cities, counties, and state governments. Municipal enterprises (tolling authorities, utilities).

Swap Market

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Interest Rate Swaps

Interest rate swaps allow an issuer to exchange fixed rate payments for variable rate payments or vice versa.

Interest Rate Swaps Have Four Basic Characteristics

1. Agreement is between two parties to exchange payments.

2. Each party agrees to make a fixed/floating payment in exchange for receiving a floating/fixed payment over a predetermined period.

3. Payments are based on a “notional” amount.

4. No principal is exchanged.Notional Amount

Party A Party B

Fixed

Floating

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Interest Rate Swaps (cont.)

The floating-to-fixed rate swap allows an issuer to convert a portion or all of an outstanding variable rate issue to a fixed rate payment structure.

Issuer receives variable payments from the swap provider and pays a fixed rate of interest to the provider. The funds received from the provider are then used to pay interest on the outstanding variable rate bonds. Synthetic Fixed Swaps act as hedge against interest rate risk.

Floating-to-Fixed Rate Swaps

Variable RateBond Holders

Variable Rate

Issuer Swap Provider

Fixed Rate

Variable Rate(BMA or Percentage

of Libor Index)

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Interest Rate Swaps (cont.)

The fixed-to-floating rate swap allows an issuer to convert a portion or all of an outstanding fixed rate issue to a variable rate payment structure.

Issuer receives fixed payments from the swap provider and pays a variable rate of interest to the provider. This transaction allows the issuer to use variable rate financing (historically lower cost) with out requiring a remarketing agent and liquidity provider.

Fixed-to-Floating Rate Swaps

Fixed RateBond Holders

Fixed Rate

Issuer Swap Provider

Fixed Rate

Variable Rate(BMA or Percentage of

Libor Index)

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Swap Options

The option buyer pays the issuer a premium upon execution of the swaption agreement.

If the swaption is exercised, the swap begins.If the swaption is not exercised, the issuer keeps

the premium and has no additional obligation to the swaption buyer.

What is a Swaption?

A Swaption is an option that gives the buyer the right, but not the obligation, to enter into a swap at a specific date in the future.

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Swap Options (cont.)

Mechanics of a Swap Option “Swaption”

Issuer

Variable Rate

Variable Rate

Swap OptionSwap Option

Fixed Rate*

Bond Holders

Swap Provider

Today: Swap provider pays issuer for the one time right to direct Issuer to enter into a Swap on the call date.

Call Date:

Option Exercised – the Issuer and swap provider enter into swap and begin exchanging variable and fixed rate payments.

Option Not Exercised - the Issuer retains the up-front payment and the ability to refund bonds in the future.

* Assume for this example the swap is a fixed payor swap

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Interest Rate Swaps and Swap Options

Advantages:Change Payment Characteristics – issuer is able to change payments on fixed rate issue to resemble payments on variable rate issues and vice versa.

Cost Savings – the swap procedure usually provides lower borrowing costs.

Disadvantages:

Counter Party Risk

The risk that the party on the other side of a swap transaction does not fulfill its obligation under the swap. If the counter party defaults on its payment to the issuer then the issuer is left with un-hedged variable rate payments.

The Value of Interest Rate Swaps and Swap Options

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Interest Rate Swaps and Swap Options (cont.)

Disadvantages (cont.):

Basis Risk

(1) the degree to which the difference between two prices fluctuates; (2) the residual risk that remains after a hedge has been placed; (3) the risk from receiving one floating rate, such as BMA or a percentage of LIBOR and paying another, such as the interest rate on your own obligations.

Example: Average Index (68% of LIBOR) is 1.50% Average cost of variable rate debt is 1.40% Difference .10%

Difference of .10% is Basis Risk. In this example the issuer receives 1.50% but only pays 1.40%. This basis differential could also be a negative amount in which case the issuer would pay more than it received, thus increasing its cost of borrowing.

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Interest Rate Swaps and Swap Options (cont.)

Disadvantages (cont.):

Tax Risk

The risk that a change in Federal or State tax law changes the issuer’s borrowing cost.

In Swaps, the risk can be identified and shared between Provider/Issuer .Any change in tax law may impact borrowing cost. An Issuer takes Tax Risk on variable rate bonds even when a Swap is not contemplated. As marginal tax rates DECREASE, floating rates on tax-free bonds will increase.

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Knockout Swaps

The knockout swap is a swap which is terminated periodically or permanently if the variable interest rate moves above or below an agreed upon level based on a specified floating rate index, generally Libor or BMA.

Advantages: Lowers Cost – when the issuer sells this option it receives a

lower swap rate or an upfront premium.

Increased Financial Flexibility – Option can be repurchased if market conditions are favorable.

Disadvantages: Uncertainty – if knockout rate is exceeded then issuer is

back to un-hedged variable rate payments. Higher Interest Costs – if swap is canceled the variable rate

may be higher than the swap rate.

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Knockout Swaps (cont.)

Mechanics of a Knockout Swap

Knockout SwapKnockout Swap

Issuer

Variable Rate

Fixed Rate

Bond Holders

Swap Provider

Today: Swap provider pays issuer or offers a lower swap rate for the option of canceling the swap if variable rate rises above a certain “knockout” rate.

Knockout rate exceeded:

The swap is canceled. The issuer pays the variable rate to the bond holders and no payments are exchanged between the bond holders and swap provider.

Fixed Rate

Variable Rate

Bond Holders

Swap ProviderIssuer No Payments

Exchanged

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Forward Delivery Contracts

Advantages: Lock in Costs - issuer locks in the cost of borrowing

today; helps with future budgeting of interest costs. Hedge Interest Rate Risk - issuer locks in rates so it is

no longer at risk if rates begin to rise.

Disadvantages: Cost of Premium - issuer must pay the forward

premium. Non-Cancelable - once agreement is entered into by

issuer, the issuer must provide the bonds or make a payment to the provider on the specified date. Thus, the issuer must be certain of the amount of funds it will need prior to entering into the Forward Delivery Contract.

Forward Delivery Contracts are fixed rate debt obligations with a settlement date sometime in the future. The Issuer pays a premium over today’s market rates.

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Forward Delivery Contracts (cont.)

Mechanics of Forward Delivery Contracts

Forward Delivery Bonds Forward Delivery Bonds Today:

Issuer sells bonds with extended delivery.

Delivery:

The Issuer delivers bonds to bond holders in exchange for purchase price agreed upon when purchase contract was signed (Today).

Result:

The Issuer locks in the negotiated interest rate starting on the delivery date through the maturity of the bonds.

Issuer

DeterminePurchase Price

Negotiate Interest Rate

Underwriter

Today

Issuer

Purchase Bonds

Deliver bondsBegin paying Negotiated

Interest RateUnderwrit

er

Delivery Date (I Year Later)

Negotiated Interest Rate = Today’s Yields + Forward Premium

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Interest Rate LocksIssuer agrees to an interest rate based on the current market (MMD index in municipal finance) plus a premium. At the settlement date a differential payment is exchanged between the two parties. The payment is based on the difference between the current rate and the locked rate. This difference is used to calculate the present value of some principal amount.

Advantages: Hedging Interest Rate Risk – issuer locks in current rates plus

premium. No Up-front Fees – issuer may receive a payment on settlement

date. Budget Planning – securing current rates for future debt issuance also

assists with planning future debt service payments as the cost of borrowing is known.

Disadvantages: Contract must be Executed – even if bonds are not issued, the terms

of the contract must be settled, which could mean a cash payment by the issuer.

Political Ramifications – if rates fall and issuer makes a payment, outsiders may view the transaction as speculative rather than risk management.

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Interest Rate Locks (cont.)

Illustration of MMD Rate LockAssume that in today’s market the MMD 30 year rate is 5.10% and that the present value of a basis point is $10,000.

Counterparty

Borrower

Effective Date5.10%

Rate Lock

Bond Pricing Date

Rates Fall 30bpsMMD = 4.80%

Rates Rise 30bpsMMD = 5.40%

Differential payment = $300,000 ($10,000 *30 bps)

Counterparty

Borrower$300,00

0

Bond Purchaser

s

Market Rate Bonds

Counterparty

Borrower$300,00

0

Bond Purchaser

s

Market Rate Bonds

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Caps, Floors and Collars

An interest rate cap is an agreement between an issuer and a interest rate cap provider that places an upper limit on the risk exposure for an issuer’s variable rate bonds.

While the interest rate on the bonds may increase above the cap, the cap provider will pay the issuer the difference in interest cost on a notional principal amount any time a specified index (BMA, 1-month LIBOR) rises above a specified “cap strike rate.”

To purchase a cap, the issuer pays an up-front premium to the cap provider.

Interest Rate Caps

Unhedged Exposure

0% 2% 4% 6% 8% 10%Interest Rates

Hedged Exposure

0% 2% 4% 6% 8% 10%

Interest Rates

Variable Rate Interest Expense

Payment fromCap Provider

Cap StrikeVariable Rate

Interest Expense

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Caps, Floors and Collars (cont.)

An interest rate floor is an agreement between an issuer and the purchaser of an interest rate floor that places a lower limit on the rate of an issuer’s variable rate bonds.

While the rate on the bonds may drop below the “floor strike rate,” the issuer agrees to pay the floor purchaser the difference in interest payable on a notional principal amount when a specified index rate (e.g BMA, 1-month LIBOR, etc.) falls below a stipulated minimum, or “floor strike rate.”

The Issuer receives a premium from the floor purchaser for this agreement.

Interest Rate Floors

Exposure After Floor

0% 2% 4% 6% 8% 10%

Interest Rates

Unhedged Exposure

0% 2% 4% 6% 8% 10%

Interest Rates

Variable Rate Interest Expense

Payment toFloor Buyer

Variable Rate Interest Expense

Floor Strike

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Caps, Floors and Collars (cont.)

An interest rate collar combines the use of a cap and a floor. The collar sets an issuer’s variable rate exposure to a predetermined range. The payment received from the floor often is used to offset the premium on the cap.

Interest Rate Collars

Collar Exposure

0% 2% 4% 6% 8% 10%

Interest Rates

Variable Rate Interest Expense

Payment from

Cap Provider

Cap StrikeFloor Strike

Payment toFloor Buyer

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Advantages: Limit Risk Exposure – through the use of caps, issuer

sets the upper limit on its variable debt service thus setting the maximum interest rate payment.

Termination of Cap or Floor – issuer can sell or extend the contracts at any time.

Premium from Floor – issuer receives a premium from the floor agreement.

Combine Cap and Floor for Collar – issuer may limit variable rate exposure to a predetermined range and apply the payment from the floor to the premium on the cap.

Disadvantages: Cost of Contract – issuer must pay an up-front premium

for cap. Floor Limits Potential Benefit – if rates fall below the

floor strike rate, the issuer loses the savings benefits from lower interest payments.

The Value of Caps, Floors and Collars

Caps, Floors and Collars (cont.)

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Summary

Using Financial Derivatives is not for every issuer or every circumstance. Municipal Issuers use derivatives for hedging only and not for market speculation.

Properly executed, financial derivatives can help municipal debt issuers lower borrowing cost and manage risk exposure.

As financial derivatives have become more popular, many municipalities have begun using derivatives as part of their financial management strategy.

"By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives.“

- Alan Greenspan, 1999

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Terms

BMAThe Bond Market Association Municipal Swap Index, produced by Municipal Market Data, is a 7 day high grade market index comprised of tax-exempt VRDOs from MMD's extensive database. This is the standard variable rate index for municipal finance.

LIBOR The London Interbank Offering Rate is the rate that most creditworthy international banks dealing in Eurodollars charge each other for loans.

Maturity or Maturity Date The date upon which the principal security becomes due and payable to the security holder.

MMD Municipal Market Data. This companies compiles municipal bond market statistical information and publishes daily statistics.

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Terms

Notional Amount The amount SWAP payment calculations are based on. The notional amount is usually the same or very close to the principal amount of the underlying bonds. The notional amount is a calculation basis only, as principal is not exchanged in a swap transaction.

Swap A sale of security and the simultaneous purchase of another security, for purposes of enhancing the investor's holdings. The swap may be used to achieve desired tax results, to gain income or principal or to alter various features of a bond portfolio, including call protection, diversification or consolidation, and marketability of holdings.

Swap Spreads The fixed spread (to Treasuries) on a Libor based fixed to floating interest rate swap. Swap spreads are effectively a proxy for spreads between Treasuries and very high-grade taxable non-Treasury bonds.

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Questions?