An introduction to municipal derivative products.

• Author: Engebretson, Kathryn
• Position: Part II

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...