Derivative investment policy in the public sector.

• Author: Jordan, Peter

In recent years, the pace of innovation in the capital markets has accelerated, leading to a proliferation of products and presenting investors with an increasingly complex array of investment choices. Derivative products are at the leading edge of this innovation. Government finance officers in their role as cash and pension fund managers are increasingly offered derivative products for potential investment.

One of the more popular forms of derivative securities purchased by government entities has been mortgage derivatives, including some collateralized mortgage obligations (CMOs). Some government entities have invested in mortgage derivatives by purchasing them directly or indirectly through their selection of investment managers, such as mutual funds. Increased volatility in these securities has caused several government entities to report multimillion dollar losses in 1994.

GFOA, recognizing the special issues of complexity and volatility of derivative securities, recently issued a recommended practice for their use. The recommendations advise that government entities should be aware of the special risks incurred as a result of the use of derivatives. These special risks include market risk, as these securities may be illiquid and highly volatile and may be leveraged. In addition, many of these securities have not been market tested over prolonged periods and in differing market environments. Assigning values to these securities, independent of trading prices, may be difficult and achieved only through sophisticated computer models - which are highly dependent on assumptions about interest rate volatility, mortgage prepayment activity and other factors. To ensure that risks are adequately managed, the recommended practice suggests that internal controls be established for each type of derivative in use.

Collateralized Mortgage Obligations

Government entities have long relied on credit ratings and/or "government-backing" as a way to define prudently acceptable risk characteristics of investment securities. High credit quality alone, however, is not sufficient to safeguard against the assumption of derivative risks.

The collateralized mortgage obligation (CMO) market attracts investors with its relatively high yield and AAA or "government agency-backed" credit quality. CMOs are sliced into unique securities, called tranches, that receive principal and interest based on the priorities defined by the payment structure. Changes in interest...