Presented by: Alfred Mukunya Director Swaps and Derivative Valuations November 2012.

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presented by: Alfred Mukunya Director Swaps and Derivative Valuations November 2012

2 PFM Asset Management LLC: May, 2012 Summary of Presentation Introduction to Interest Rate Swaps Swap Pricing and Valuation New Developments in Valuations (OIS curve discounting) GASB 53 & 64 ASC 820 Fair Value Appendix A: Case Studies & Suggested Accounting Appendix B: Barclays OIS Paper

Introduction to Interest Rate Swaps

4 PFM Asset Management LLC: May, 2012 Interest Rate Swaps in General An interest rate swap is a contract between two parties (“counterparties”) to exchange interest rate payments at specified dates in the future. The interest rate payments for a given counterparty equal the product of an interest rate (swap rate) and a principal amount. Usually, the swap rate for one counterparty is a fixed rate, while the swap rate for the other counterparty is a variable rate. The principal amount by which the swap rates are multiplied is “notional”. That is, principal payments are not swapped, paid or exchanged; the notional principal amount is only an arithmetic device to calculate swap payments. Counterparty A Counterparty A Counterparty B Counterparty B Fixed Payments (Fixed interest rate X notional principal amount) Floating Payments (Variable interest rate X notional principal amount)

5 PFM Asset Management LLC: May, 2012 Floating-To-Fixed Swap (“Synthetic Fixed”) A floating-to-fixed interest rate swap allows an issuer to effectively convert all or a portion of its variable (floating) rate debt to a “synthetic” fixed rate The issuer becomes a “fixed rate payor”, receiving a floating rate payment from a counterparty and paying a predetermined fixed rate To the extent the variable rate received by the issuer offsets the variable rate paid by the issuer to bondholders, the issuer’s debt cost equals the fixed swap rate plus any ancillary fees 30-Yr Synthetic Fixed Example Pay Fixed Swap Rate: 2.65% Rec Floating Swap Rate: (SIFMA) Pay VRDB Rate: SIFMA Pay Liquidity/Remarketing: 0.75% Net: 3.40%

Swap Pricing and Valuation

7 PFM Asset Management LLC: May, 2012 Market Rates There is an actively traded inter-dealer broker market for interest rate swaps

8 PFM Asset Management LLC: May, 2012 Swap Pricing - Approach to Market Value Fixed swap rate is the breakeven rate that sets the present value of the fixed payments equal to the present value of the expected floating, e.g. LIBOR payments –Expected floating payments are calculated using implied forward rates which can be derived from exchange traded Eurodollar futures Price or value of a swap = present value of fixed leg - present value of floating leg Price of an “at the market” swap = 0 An “off market” swap has value to one party and requires an up-front cash payment to compensate for “off-market” rate Additional features, such as embedded caps, floors and swaptions, can be decomposed and independently valued.

9 PFM Asset Management LLC: May, 2012 Swap Termination Calculation Methodology For a plain-vanilla interest rate swap: –The existing swap is compared to a hypothetical at-market “mirror offset” swap with identical terms Floating leg re-valued to next reset date (value equals zero if calculated on a rate reset date) Fixed leg value equals PV of difference between the fixed payments on the old and mirror swap –All discounting normally done at dealer’s (taxable) cost of capital Issuer Swap Dealer Floating Rate Old Fixed Rate Floating Rate New Fixed Rate Existing Swap Mirror Offset Swap Issuer

10 PFM Asset Management LLC: May, 2012 A Sample Swap Valuation The issuer would be required to pay \$1,903,864 to terminate this swap Scenario: 8 years ago an issuer entered into a 10-year Pay Fixed swap Notional Amount: \$100,000,000 Existing Fixed Rate Paid by Issuer: 5.00% Current Market Fixed Rate for 2-year swap: 4.00% Fixed Payments @ Present Period5.00%4.00%DifferenceValue 12,500,0002,000,000-500,000-490,196 22,500,0002,000,000-500,000-480,584 32,500,0002,000,000-500,000-471,161 42,500,0002,000,000-500,000-461,923 Swap value =(1,903,864)

11 PFM Asset Management LLC: May, 2012 Swap Termination Matrix A swap termination matrix can be used for sensitivity analysis Swap Term (Years): 10.0 Notional Amount: 100,000,000\$ Contract Swap Rate: 5.00% Payment Frequency: 2 Issuer Pays: Fixed Change in Swap Rate Remaining Term of Swap (in Years) -1.00%-0.50%0.00%0.50%1.00% 10(\$8,175,717)(\$3,990,928)\$0\$3,806,813\$7,438,737 9(\$7,496,016)(\$3,666,915)\$0\$3,512,192\$6,876,757 8(\$6,788,855)(\$3,328,158)\$0\$3,201,143\$6,280,551 7(\$6,053,124)(\$2,973,985)\$0\$2,872,752\$5,648,037 6(\$5,287,671)(\$2,603,695)\$0\$2,526,051\$4,977,002 5(\$4,491,293)(\$2,216,554)\$0\$2,160,019\$4,265,101 4(\$3,662,741)(\$1,811,796)\$0\$1,773,579\$3,509,846 3(\$2,800,715)(\$1,388,619)\$0\$1,365,592\$2,708,596 2(\$1,903,864)(\$946,185)\$0\$934,857\$1,858,549 1(\$970,780)(\$483,617)\$0\$480,106\$956,735 TERMINATION PAYMENT AMOUNT

12 PFM Asset Management LLC: May, 2012 Mechanics of Fuel Price Swap Hedger is normally a “fixed rate (price) payer” on swap Floating index typically used in energy hedging is published price from an industry trade publication, e.g. Platt’s Oilgram Can specify physical or cash settlement on contract –Physical settlement exposes hedger to force majeure events Counterparty Diesel Fuel Supplier Variable Price \$/gal Fixed Price \$/gal ULS Diesel Index Price \$/gal Hedger

New Developments in Valuations (OIS curve discounting)

14 PFM Asset Management LLC: May, 2012 New Developments in Valuations/Modeling  [Counterparty] will value OTC derivative transactions using rates to discount expected cash flows under the transactions reflecting the terms of any CSA (considering factors such as the yield of the eligible assets which may be posted as collateral, rather than a standard discount curve based upon LIBOR, and ‘projection’ curves derived from market standard instruments).  From a major bank:

15 PFM Asset Management LLC: May, 2012 Swap Discount Curves — New and Old as of May 15, 2012

16 PFM Asset Management LLC: May, 2012 New Developments in Valuations/Modeling USD LIBOR Curve vs. Overnight Index Swap (OIS) Curves — \$100MM 20 year swap LIBOR DiscountingOIS Discounting Impact: (\$24.60MM) vs. (\$25.17MM) = (\$0.57MM) Rate Equivalent: 3.5 basis points (0.035%)

GASB 53 & 64

18 PFM Asset Management LLC: May, 2012 Market Environment During GASB 53 Implementation 20 Year USD-LIBOR from 2000 to Present

19 PFM Asset Management LLC: May, 2012 Low Rates Persist — Compared to Initial Transactions 20 Year Tax- Exempt Rate 2001 to Present –Level of interest rates are key drivers of Fair Value –Most borrowers hedge against rising interest rates –Results in relatively large liabilities

20 PFM Asset Management LLC: May, 2012 GASB 53 Summary Review The following are the three core concepts of GASB 53: 1.Report the fair value of a derivative on the statement of net assets (balance sheet). 2.All hedges must be evaluated for effectiveness (methods outlined in the Statement, applied in stepladder fashion). 3.Recognize changes in the fair value - of the derivative either: a) on the balance sheet or statement of net assets, as deferred inflows or deferred outflows if the derivative passes its effectiveness test; OR b) as investment revenue/loss (i.e., gain or loss through statement of revenues, expenses, changes in fund net assets, as appropriate) if the derivative fails, or is not a hedge. The government must also provide a summary of activity through the reporting period

21 PFM Asset Management LLC: May, 2012 Primary Issuer Concerns of GASB 53 (in order of importance) New asset/liability effect on bond covenant ratios Potential investment revenue/loss effect on bond covenant ratios Potential Board, Investor, Press impact of recording new liabilities/losses Potential of recording large loss upon losing effectiveness (Headline risk) Additional training and compliance cost

22 PFM Asset Management LLC: May, 2012 What are the Pros and Cons? ProsCons Consistent Critical Terms Easy to implementNo flexibility for other types of swaps Quantitative Methods Synthetic Instruments Relatively easy to implement; Uses observed bond and swap data Could fall out of range in differing rate environments Dollar Offset Conceptually easy to implement –just another hypothetical “perfect” trade Unpredictable and subjective if hedging and hedged rates do not move significantly, and in tandem. Regression Analysis Favorite among ASC 815; Has worked well historically Relatively harder to implement; Needs statistical knowledge Other Quantitative Methods Flexible, as long as one can justify Too much subjectivity, and need to document procedure

23 PFM Asset Management LLC: May, 2012 How to Account for an Effective Hedge (Journal Entries)? When a derivative is an effective hedge and its value goes up by \$1,000,000 When a derivative is an effective hedge and its value goes down by \$1,000,000 DateAccount TitlesDebitCredit June 30, 20XXSwap1,000,000 Deferred Inflow1,000,000 DateAccount TitlesDebitCredit June 30, 20XXDeferred Outflow1,000,000 Swap1,000,000

24 PFM Asset Management LLC: May, 2012 What Happens to an Ineffective Hedge (Journal Entries)? When a derivative is an ineffective hedge and its value goes up by \$1,000,000 When a derivative is an ineffective hedge and its value goes down by \$1,000,000 DateAccount TitlesDebitCredit June 30, 20XXSwap1,000,000 Investment Revenue1,000,000 DateAccount TitlesDebitCredit June 30, 20XXInvestment Loss1,000,000 Swap1,000,000

25 PFM Asset Management LLC: May, 2012 2. Refundings and Restructurings 2008 through 2011 – Timeline Linking Market and Accounting Events GASB 53 Effective, periods after 6/15/2009 Lehman Bankruptcy 9/15/08 Bear Stearns Collapse 3/08 GASB 53 Release 6/08 GASB 53 In effect: 7/1/2010 20 Year LIBOR Swap Rate: 2.80% 12/31/2008 20 Year LIBOR Swap Rate: 5.81% 6/30/07 GASB 53 Implementation for most Issuers: 20 Year LIBOR Swap Rate: 3.59% Fiscal Year Ending 6/30/08 6/30/09 6/30/106/30/11 A.Fixed Payer Swaps B.Forward Swaps C.Swaptions D.Basis Swaps Defaults result in swap assignments from one counterparty to another. Swaption exercises; Swap Modifications from SIFMA to 67% of LIBOR; Swaps paired to other bonds; Terminations. A.Auction Rate Security (ARS) B.Anticipated Issuance C.Advance Refunding D.Fixed Rate Bond Conversion/Reissuance from ARS to Variable Rate Demand Bond (VRDB), or bank notes. Refunding Bonds issued; Refunding Bonds not issued; Fixed Rate Bonds issued; Anticipated Bonds not issued. Market Events Hedges Hedged Items Hedge & Hedged Item Events GASB 64 Release 6/11 GASB 64 Effective, periods after 6/15/2011

26 PFM Asset Management LLC: May, 2012 GASB 64 in Effect, Fair Value Measurements Coming Up 20 Year LIBOR Swap Rate: 3.94% 6/30/11 9/30/11 12/31/11 3/31/12Fiscal Year Ending 6/30/12 GASB 64 In effect: 7/1/2011 Fair Value Measurement Task Force Formed 2/12 Fair Value Measurement Exposure Draft Expected 11/12 TodayToday 20 Year LIBOR Swap Rate: 2.60% 9/30/11 20 Year LIBOR Swap Rate: 2.50% 12/31/11 20 Year LIBOR Swap Rate: 2.91% 3/31/12 20 Year LIBOR Swap Rate: 2.3655% 6/30/12

27 PFM Asset Management LLC: May, 2012 Credit Support Credit Support pulldown for access to more detail. Credit Support Function

ASC 820 Fair Value

29 PFM Asset Management LLC: May, 2012 The New Accounting Standards Codification (ASC) The Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) has changed the structure and hierarchy of accounting standards. FASB ASC disassembled and reassembled thousands of accounting pronouncements (Statements, Issues, etc.) to organize them under approximately 90 topics, and Accounting Standards Updates (ASU). FASB issued the last Statement No. 168 in June 2009 establishing FASB ASC as the source of authoritative US accounting and reporting standards for nongovernmental entities. This is effective for periods ending after September 15, 2009. FAS 157 is now known as FASB ASC 820 or ASC 820.

30 PFM Asset Management LLC: May, 2012 ASC 820 Reporting Requirements 30

31 PFM Asset Management LLC: May, 2012 ASC 820 and ASU No. 2010-06 Summary: Fair Value Definition Fair value shall reflect the nonperformance risk of the client counterparty relating to that liability Fair value shall reflect the nonperformance risk of the bank counterparty relating to that asset Fair Value Hierarchy based on Valuation Technique/Input Inputs to generate the valuation are classified into three different Levels –Level 1 – Quoted prices –Level 2 – Observable inputs –Level 3 – Unobservable inputs Disclosure is made of the Level within which the Fair Value falls PFM will help compute Fair Value Measurements for any Asset/Liability requiring compliance with ASC 820.

32 PFM Asset Management LLC: May, 2012 ASC 820 Outline of Methodology Determine nonperformance risk free valuation –Old definition of fair value, e.g. using a mid LIBOR curve Absent nonperformance risk, determine whether asset or liability Absent nonperformance risk, determine which counterparty is at risk of nonperformance Create a counterparty specific discounting curve based on: –A: Relevant, Observable (Level 2) industry, sector, geographic curves, e.g. Fair Market Curves on Bloomberg, or Thomson Financial. –B: Unobservable (Level 3) client specific curve adjustments – if necessary Compute a risk adjusted valuation using the counterparty specific discounting curve The difference between the nonperformance risk free valuation and risk adjusted valuation is the transaction’s risk adjusted amount In the simplest case, this is the Credit Value Adjustment (CVA) to apply to the nonperformance risk free valuation to get the Fair Value under ASC 820

Appendix A: Case Studies & Suggested Accounting

34 PFM Asset Management LLC: May, 2012 Case Studies - Outline 1.Refunding and Restructuring Changes in Hedging Item Changes in Hedged Item Imputed Borrowings 2.GASB 64 Update 3.Swaption Bifurcation -Trifurcation (contains all aspects of GASB 53) Investment Borrowing Hedge

35 PFM Asset Management LLC: May, 2012 Refundings (Hedged Item Events) and Restructurings (Hedging Item Events) Situation: FY ending June 2010 - Off-market SIFMA swap with up front amount received at inception. - booked as a hybrid instrument consisting of a borrowing and an at-the-market SIFMA swap as of June 30, 2010. During FY ending June 2011 floating leg of the swap is amended from SIFMA to 67% of USD LIBOR resulting in a lower fixed rate for the rest of the life of the swap. No cash changes hands. Suggested treatment: new hybrid instrument accounted for as: a)Termination of at-the-market SIFMA swap Clear out associated deferral account b)New imputed borrowing of fair value of terminated at-the-market SIFMA swap To be amortized over the life of the new at-the-market 67% of LIBOR swap c)New at-the-market 67% of LIBOR swap Amended swap terminates the old d)Old borrowing of upfront amount received at inception of original transaction Continues to be amortized over remaining life

36 PFM Asset Management LLC: May, 2012 Refundings (Hedged Item Events) and Restructurings (Hedging Item Events) Situation: During FY ending June 2012, Bank Counterparty seeking to exit municipal derivatives business agrees with issuer to novate a swap transaction to another Bank Counterparty. Suggested treatment: a)Viewed by the Board as a termination that changes a government’s financial position, therefore Clear out associated deferral account Gain/Loss is recognized in Statement of Activities b)New off-market swap, with Imputed At-the-Market Swap, and Fixed Rate Imputed Debt. The above market portion of the swap is an imputed borrowing Government could have paid off the fair value of swap by a borrowing

37 PFM Asset Management LLC: May, 2012 Swaptions Background - The Bite at the Apple: –Municipal bond issuers often have the right to call and refund fixed-rate bonds at par (face), typically 10 years after issuance of the debt. –The right to call tax-exempt debt is restricted by the call date and the Treasury rules for tax-exempt debt. Advance refundings are possible but restricted by tax law to one per bond issue. Funds must be escrowed to the call date and costs may impact efficiency. –Ability to refund bonds has been described as a “bite at the apple” to signify the one-time only decision. –Traditionally, an issuer would wait until the call date, call the bonds and issue new refunding bonds at lower interest rates. –Benefit of a traditional refunding is recognized through lower interest cost over time.

38 PFM Asset Management LLC: May, 2012 Swaptions Synthetic (as opposed to Traditional) Refunding: –Issuer possesses the right (option) to call their outstanding fixed-rate bonds. –The option increases in value as rates fall. –Swaption sale allows the Issuer to synthetically forward refund the Bonds to lock in savings based on prevailing market conditions. –Aggregate premium received by the Issuer composed of two elements Intrinsic value – the amount by which the fixed rate commitment (strike) of the option exceeds the prevailing interest rate (at-the-money) and Time value of the option – the amount above the intrinsic value which a banker will pay the issuer based on the probability the option will increase more in value between the premium payment date and maturity of the option. –Swaption sale monetizes the option embedded in the callable bonds. Prior to a current refunding Swaption is structured to mirror the optional redemption features of the Bonds.

39 PFM Asset Management LLC: May, 2012 Swaption Accounting Illustration 11 – Hybrid Instrument Bifurcation –Embedded Derivative Instrument Time Value Goes to zero at maturity of the swaption Will change depending on prevailing rates –Borrowing Instrinsic Value, carried at Historical Cost –Rates fell significantly since inception of most swaptions –Differences interpreting definitions in the Standard, and how to compute the components based on the definitions resulted in material differences of opinion in what to book. –For example: Does the Embedded Derivative Instrument value result from subtracting the prevailing intrinsic value? Or the historical borrowing? Is it only the time value? What about the large increases/decreases in the fair value of the entire swaption?

40 PFM Asset Management LLC: May, 2012 Swaption Accounting Swaption Trifurcation –Embedded Derivative Instrument Time Value. Goes to zero at maturity of the swaption. Will change depending on prevailing rates. –Borrowing Instrinsic Value, carried at Historical Cost. –At-the-Money Swap Originally at zero cost. Reflects the original intent of the Issuer to refund in the future. The prevailing at-the-money swap rate at inception is the beneficial fixed rate the issuer has locked in upon selling the swaption.

Appendix B: Barclays OIS Paper

42 PFM Asset Management LLC: May, 2012 This material is based on information obtained from sources generally believed to be reliable and available to the public, however PFM Asset Management LLC cannot guarantee its accuracy, completeness or suitability. This material is for general information purposes only and is not intended to provide specific advice or a specific recommendation. All statements as to what will or may happen under certain circumstances are based on assumptions, some but not all of which are noted in the presentation. Assumptions may or may not be proven correct as actual events occur, and results may depend on events outside of your or our control. Changes in assumptions may have a material effect on results. Past performance does not necessarily reflect and is not a guaranty of future results. The information contained in this presentation is not an offer to purchase or sell any securities.

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