An introduction to municipal derivative products.

• Author: Engebretson, Kathryn
• Position: Part 2 - Risk factors of municipal derivative products

Inverse floaters/floaters, floaters hedged with swaps, bull/bear securities and indexed/fixed-rate bonds conclude Government Finance Review's two-part discussion of municipal derivative products and the risk factors associated with their use.

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 trade names or acronyms, like RIBS/SAVRS, PARS/INFLOS and bull/bear floaters, and partial fixed/partial floating-rate products such as indexed bonds.

While some of 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. Although derivatives may be useful to government finance officials in managing debt and reducing total interest payments, there may be risks associated with these products. Therefore, it is 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 articles explaining how swaps work, how an issuer may analyze their usefulness and 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 previous installment of this overview of derivative products, which appeared in Government Finance Review in February 1993, discussed interest rate caps, floors and collars. This article will focus on other derivative products: inverse floaters/floaters, inverse floaters hedged with swaps, bull/bear floaters and indexed/fixed-rate bonds.

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...