Reporting Requirements for Annual Financial Reports of State Agencies and Universities

Notes & Samples

NOTE 7 – Derivative Instruments
Sample Overview

The primary focus of this note is to provide an overview of the agency’s derivative instrument activity and to serve as a central place for the summary disclosure of all derivative instruments, investment, hedging and other derivative instruments (those which do not meet the definition of an investment derivative instrument or the effectiveness criteria of a hedging derivative instrument). Organize the note into the following sections:

1. Introduction
2. Summary of derivative instrument activity and discussion of fair value determination
3. Hedging derivative instruments
   1. Objectives
   2. Terms
   3. Risks
   4. Swap payments and associated debt
4. Investment derivative instruments disclosures
5. Other derivative instruments
6. Derivative Instruments with Contingent Features
7. Synthetic guaranteed investment contracts

Derivatives terminated during the fiscal year:

• For hedging derivative instruments, disclose the:
  • Hedging derivative instruments on the summary of derivative instrument activity table
  • Terms
  • Timing of termination (terminated during the fiscal year)
• For investment derivative instruments, disclose the:
  • Investment derivative instruments on the summary of derivative instrument activity table
  • Timing of termination (terminated during the fiscal year)
• For other derivative instruments, disclose the:
  • Other derivative instruments on the summary of derivative instrument activity table
  • Timing of termination (terminated during the fiscal year)

For specific examples of the disclosure requirements, see the Sample below.

Sample (Illustrative, may not tie to exhibits)

Derivative instruments are financial instruments whose values are derived in whole or in part from the value of any one or more underlying assets or index of asset values. Derivative instruments include:

• Swap contracts
• Futures contracts
• Options
• Options on futures contracts
• Forward contracts

Hedging derivative instruments are entered into to reduce the overall cost of borrowing long-term capital and to protect against the risk of rising interest rates. The hedging derivative instruments primarily consist of interest rate swap agreements entered into in connection with long-term bonds. The derivative instrument contracts enable the agency to issue bonds at a cost less than what the agency would have paid to issue conventional fixed-rate debt.

Investment derivative instruments are entered into with the intention of managing transaction risk, reducing interest cost or reducing currency exchange risk in purchasing, selling or holding investments. Ineffective hedges are also reported as investment derivative instruments.

The following disclosures summarize Sample Agency’s derivative instrument activity as reported in the financial statements.

Summary of Derivative Instrument Activity

The fair value of effective hedging derivative instruments is recorded as either:

• Derivative instrument assets — positive fair value
  –OR–
• Derivative instrument liabilities — negative fair value

The cumulative change in fair value of effective hedging derivative instruments is reported as deferred inflows and deferred outflows. Sample Agency’s cumulative derivative instrument activity as of Aug. 31, 20CY, is summarized in the following table. The notional values are presented in U.S. dollar equivalents.

Summary of Derivative Instruments

As of Aug. 31, 20CY, Sample Agency determined the pay-fixed, receive-variable interest rate swap listed under “business-type activities” no longer met the criteria for an effective hedging derivative instrument. Accordingly, the swap is reported as an investment derivative instrument. The accumulated changes in fair value of the swap reported as a deferred outflows of resources of $2,300,000 at Aug. 31, 20PY, and the increase in the fair value of the swap in fiscal 20CY of $200,000 are netted ($2,100,000) and reported within the “investment revenue classification” for fiscal 20CY.

Fair Value

Derivative instruments are recorded at fair value. The fair values of the interest rate swaps were determined using the zero-coupon method. Several of the effective interest rate swaps contain a provision that provides for Sample Agency to be “knocked out” of the swaps by the respective counterparties upon the breach of certain predetermined barriers. In each of these cases, Sample Agency was paid an up-front option premium by the respective counterparties. The knock-out provisions are an integral part of the associated swaps, and the fair values of the swaps include the effects of the knock-outs.

Futures contracts are marked-to-market daily and valued at closing market prices on the valuation date. A daily variation margin (the gain or loss) between the daily value of the contracts and the value on the previous day is recorded and settled in cash with the broker the following morning. Options and swaps are valued using broker quotes, proprietary pricing agents or appropriate pricing models with primarily externally verifiable model inputs.

The fair value of forward currency contracts is estimated by adding the forward points to the corresponding spot rate. These rates are then applied to the outstanding currency exchange to derive a change in valuation.

Hedging Derivative Instruments

Sample Agency entered into interest rate swap agreements with various counterparties (all of which are highly rated financial institutions) to manage various risks associated with Sample Agency’s debt programs.

Each of the interest rate swaps is a contractual agreement entered into between Sample Agency and a counterparty under which each party agrees to exchange periodic fixed or variable payments, based upon a stated notional amount, over the stated life of the agreement. The net differential paid or received is recognized over the life of the agreement as an adjustment to interest expense. Interest rate swaps determined to be hedging derivative instruments are designated as cash flow hedges. Sample Agency also entered into commodity forward contracts to hedge against the risk associated with the future purchase of natural gas. The specific objectives for each category of effective hedges are summarized as:

• Pay-Fixed, Receive-Variable Interest Rate Swaps — The combination of these swaps and variable-rate bonds creates synthetic fixed-rate debt. The use of synthetic fixed-rate debt has historically lowered Sample Agency’s borrowing costs, as compared to the borrowing costs associated with the issuance of traditional fixed-rate bonds.
• Pay-Variable, Receive-Fixed Interest Rate Swaps — Sample Agency is currently a party to one pay-variable, receive-fixed interest rate swap associated with a taxable variable-rate bond issue. The swap was overlaid on an existing pay-fixed, receive-variable swap and effectively results in unhedged variable-rate bonds with an expected borrowing cost significantly below market over the life of the swap.
• Commodity Forward — Sample Agency enters into commodity forward contracts to meet the objective of hedging the risk that changes in the market price of natural gas will adversely affect the cash flows of the expected purchase of natural gas. The outstanding commodity forward contracts as of Aug. 31, 20CY, include contracts with future expiration dates extending from September 20FY through August 20FY. Contracts will be cash-settled on the expiration date based on New York Mercantile Exchange (NYMEX) market price.

Significant Terms and Credit Ratings

The significant terms and credit ratings of Sample Agency’s hedging derivative instruments as of Aug. 31, 20CY, are shown in the following tables. The variable rates are quoted in terms of a percentage of the Fallback Secured Overnight Financing Rate (SOFR) or Securities Industry and Financial Markets Index (SIFMA) rates as noted. Standard and Poor’s and Moody’s Investors Service credit ratings are disclosed for each swap and forward contract. The notional amount for the commodity forward is expressed as MMBTUs — representing a million British thermal units.

Hedging Interest Rate Swaps: Significant Terms and Credit Ratings

Hedging Forward Contracts: Significant Terms and Credit Ratings

Risks

Credit Risk — Sample Agency is exposed to credit risk if the counterparty to an interest rate swap fails to meet the terms and obligations of its contracts.

Sample Agency mitigates the credit risk associated with its swaps by entering into transactions with a diversified group of highly-rated counterparties. The interest rate swap agreements also contain varying collateral agreements and insurance policies with the counterparties. Posted collateral may be held either by Sample Agency or by a quality third-party custodian.

Swap contracts with a negative fair value do not expose Sample Agency to credit risk. As of Aug. 31, 20CY, Sample Agency was not exposed to credit risk because the swap recorded in the positive position was offset by other swaps with negative fair values. The aggregate fair value of hedging derivative instruments in asset (positive) positions is $4.6 million. This amount is solely comprised of the pay-variable, receive-fixed interest rate swap. This swap was overlaid on an existing pay-fixed, receive-variable swap and effectively results in unhedged variable-rate bonds with an expected borrowing cost significantly below market over the life of the swap. The net between the related swaps results in a negative position.

Interest Rate Risk — Sample Agency is exposed to interest rate risk on its interest rate swaps.

On the pay-variable, receive-fixed interest rate swap, the Sample Agency’s net payment on the swap increases as the SOFR increases. Alternatively, on the pay-fixed, receive-variable interest rate swaps, Sample Agency’s net payment on the swap increases as SOFR and the SIFMA swap index decreases. For the related hedged variable rate debt, Sample Agency’s interest payments on the bonds decrease as the SOFR or SIFMA index decrease. The value of interest rate swap agreements with a longer weighted average maturity tend to be more sensitive to changing interest rates, and therefore, more volatile than those with shorter maturities.

Basis Risk — Sample Agency is exposed to basis risk to the extent that the interest payments on its variable-rate bonds do not match the variable-rate payments received on the associated swaps.

Sample Agency mitigates this risk by:

• Matching the notional amount and amortization schedule of each swap to the principal amount and amortization schedule of each associated variable-rate bond issue
  –AND–
• Selecting an index for the variable-rate leg of each swap that is reasonably expected to closely match the interest rate resets on the associated variable-rate bonds over the life of each bond issue

Additionally, tax-exempt interest rates can change without a corresponding change in taxable interest rates due to factors affecting the tax-exempt market that do not have a similar effect on the taxable market.

Sample Agency is exposed to basis risk on its commodity forward contracts because the expected commodity purchase will be priced based on a pricing point of Waha Natural Gas Hub, while the hedging forward contract is expected to settle on the NYMEX pricing point. As of Aug. 31, 20CY, the Waha price was $X.XX per MMBTU and the NYMEX price was $X.XX per MMBTU.

Termination Risk — Termination risk is the risk that the swap may be terminated prior to its scheduled maturity date as a result of certain specified events. The swap associated with the Sample Bond Series 2000A provides the counterparty with the option to terminate the swap under certain conditions at any time.

Sample Agency or the counterparties may terminate any of the swaps if the other party fails to perform under the terms of the respective swap agreements. If any of the swaps are terminated, the associated variable-rate bonds would no longer have a synthetic fixed rate and Sample Agency would be subject to interest rate risk to the extent that the variable-rate bonds were not hedged with another swap or with variable-rate assets. Unless there is a termination option exercised by the counterparty, Sample Agency would owe the counterparty a termination payment equal to the swap’s negative fair value.

Several swap agreements include optional early termination provisions granting Sample Agency the right, but not an obligation, to terminate the interest rate swaps at par without a termination payment after an effective date or after the breach of certain counterparty credit ratings.

Rollover Risk — Rollover risk is the risk caused by a mismatch between the amortization of a derivative instrument contract and the underlying hedged bonds.

None of Sample Agency’s effective interest rate swaps are subject to rollover risk because the maturity dates of the swaps extend to the maturity dates of the related bonds.

Market-access Risk — Each swap associated with underlying variable rate debt is subject to tender at the option of the bondholder and is subject to market access risk.

In the event Sample Agency is unable to remarket its variable rate bonds, Sample Agency may choose to refund the variable rate bonds with fixed-rate bonds and optionally terminate the related interest rate swap agreements. If an early termination event occurs, Sample Agency could be required to pay or to receive a substantial termination payment.

Swap Payments and Associated Debt

Aggregate debt service requirements of Sample Agency’s variable rate debt and net receipts/payments on associated hedging derivative instruments are disclosed in Note 6.

Contingent Features

Some of Sample Agency’s derivative instruments include provisions requiring the posting of collateral in the event that the Sample Agency’s credit rating falls below a specified level as issued by Moody’s Investors Service and Standard & Poor’s. If Sample Agency fails to post eligible collateral, the derivative instrument may be terminated by the counterparty. Sample Agency discloses more detail about derivative instruments with contingent features in Note 15.

Investment Derivative Instruments

Sample Agency classified its derivative instruments in Level 2 of the fair value hierarchy. These are valued using a market approach that considers benchmark interest rates and foreign exchange rates.

Investment derivative instruments expose Sample Agency to certain investment related risks. Sample Agency discloses more detail about investment derivative instruments in Note 3.