Swap Market Pricing

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• Swap Market Pricing
• December 6, 2004

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Swap Market Pricing
Comparative Yield Curves
Yield()

Includes 25 basis points for liquidity and
remarketing
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Swap Market Pricing

• The LIBOR Swap Curve Is Derived By Adding A Swap
  Spread To The Treasury Yield Curve.

LIBOR Swap Rate
TreasuryYield
Swap Spread
Maturity
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Swap Market Pricing

• The BMA Swap Curve Reflects Current Long-Term
  Taxable Interest Rates and Credit Spreads and
  Future Expected Short-Term Taxable / Tax-Exempt
  Ratios.

(C)
(A)
(B)
LIBOR Swap Curve(A B)
LIBOR Indexed Swap Spreads
Years to Maturity
On-the-Run Treasury Rate
BMA/LIBOR Percentage
BMA Swap Curve (A B) x C
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Swap Market Pricing

• The BMA swap curve is derived by multiplying a
  percentage to the LIBOR swap curve.
• The BMA Percentage represents the markets
  expectation of the future BMA / 1-Month LIBOR
  ratio .

As of November 30, 2004
As of January 3, 2002
BMA Percentage
BMAPercentage
Maturity
Maturity
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Swap Market Pricing
Mid Market Rate Execution Cost Credit
Reserve Profit All-In Swap Rate
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Swap Market Pricing

• Indirect factors Which Influence Swap Pricing
• Supply of Bonds
• Demand for Bonds
• Hedging Activity (e.g. corporate issuance)
• Credit Perceptions (e.g. Long-Term capital
  situation)
• Mortgage Prepayments
• Etc.

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• Hedging Debt Issuance
• with Swaps
• December 6, 2004

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A New Market Environment Rising Interest Rates

• The Federal Reserve began tightening the Fed
  Funds Rate at the June 30th FOMC meeting in
  response to signals of a strengthening economy.
• Bear Stearns Economist is currently projecting
  sharp increases in rates
• Federal Funds target rate to 3.80 by the end of
  2005
• Ten-year Treasury rate to 5.80 by the end of 2005

Historical Interest Rates and Bear Stearns
Projection
Yield
Bear StearnsProjectedIncreases
10-Year Treasury



Fed Funds Target Rate
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Rate Lock - General

• A rate lock is designed to hedge an issuers
  interest cost for a future issue of bonds.
• The rate lock mechanics include locking in a rate
  prior to bond pricing and, at pricing, an
  exchange of payments which reflect the subsequent
  change in rates
• The issuer receives a payment from the provider
  if the actual rate is higher than the locked rate
• The issuer makes a payment to the provider if the
  actual rate is lower than the locked rate
• The amount of the payment is intended to equal
  the present value of the increase or decrease in
  interest rates vs. the locked rate

Rate Lock Mechanics
Potential Outcomes
One Time Payment(If index is lt locked rate)
Index () Payment by Bear Stearns Payment by
Issuer

Issuer
BEAR STEARNS
YIELD ()
Locked Rate ()

One Time Payment(If index is gt locked rate)
ActualRates
PV ()
Locked Rate
PV ()
Proposed Bonds
Bond Pricing
Rate Lock Execution
TIME
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Rate Lock - General

• Rate lock contracts are based on objective market
  indices rather than the issuers actual assumed
  market-based bond rate.
• Rate lock agreements, therefore, do not guarantee
  the issuers actual market yield on its bonds.
• The issuers effective interest rate at bond
  closing is equal to the locked index rate plus or
  minus the issuers trading differential vs. the
  index.
• The issuer maintains the risk that its bonds,
  when issued, will trade at a different spread to
  the hedged index (i.e., the issuer has basis
  risk).

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Hedging Alternatives

• There are a number of alternatives that enable
  Issuers to hedge the interest cost associated
  with future issuance of debt.
• MMD Rate Lock
• BMA Forward Starting Swap
• LIBOR Forward Starting Swap

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Rate Lock - Cost vs. Basis Risk
Cost
Basis Risk
MMD Rate Lock Highest Lowest BMA Swap LIBOR
Swap Lowest Highest
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MMD Rate Lock

• In an MMD rate lock, the issuer and the provider
  agree
• On a notional amount and average life which
  should approximate the hedged bonds
• On the duration of the rate lock
• On a locked MMD AAA rate based on current rates
  plus a forward premium and
• The amount of money per basis point which will be
  paid in the event that MMD AAA rates are
  different from the locked rates upon expiration
  of the agreement.
• MMD rate locks are Cash Settled

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BMA Swap Rate Lock

• In a BMA Swap rate lock, the issuer and the
  provider agree
• On the notional amount and term of the swap which
  should approximate the hedged bonds
• On the duration of the rate lock and
• On a forward BMA swap rate based on the current
  market plus a forward premium.
• A termination payment is made at the expiration
  of the rate lock which reflects the then current
  market value of the underlying swap or the
  Issuer can enter into the BMA swap at the
  locked-in rate.

Receive Payment Issue Fixed Rate Bonds
Cash Settle
Rates Higher
Physical Settle
Enter into BMA Swap Rate Lock
Issue Floaters
Physical Settle
Rates Lower
Cash Settle
Make Payment Issue Fixed Rate Bonds
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67 of LIBOR Swap Rate Lock

• In a 67 of LIBOR swap rate lock, the issuer and
  the provider agree
• On the notional amount and term of the swap which
  should approximate the hedged bonds
• On the duration of the rate lock and
• On a forward 67 of LIBOR swap rate based on the
  current market plus a forward premium.
• A termination payment is made at the expiration
  of the rate lock which reflects the then current
  market value of the underlying swap or the
  Issuer can enter into the 67 of LIBOR swap at
  the locked-in rate.

Receive Payment Issue Fixed Rate Bonds
Cash Settle
Rates Higher
Physical Settle
Enter into LIBOR Swap Rate Lock
Issue Floaters
Physical Settle
Rates Lower
Cash Settle
Make Payment Issue Fixed Rate Bonds
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Basis Risk BMA Swap Hedge

• Municipal bonds are highly correlated to BMA
  swaps. A BMA hedge will outperform an MMD hedge
  if spreads narrow and under perform if spreads
  widen.

Spread Current 31.787
bps Min (4.636) bps Max
57.950 bps Average 30.211 bps
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Basis Risk LIBOR Swap Hedge

• Municipal bonds are correlated to LIBOR swaps. A
  LIBOR hedge will outperform an MMD hedge if
  spreads narrow and under perform if spreads widen.

Spread Current 91.543
bps Min 61.635 bps Max
132.033 bps Average 95.323 bps
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Summary of Decisions
Decide

• Decide Today
• Do Nothing
• Rate Lock
• MMD
• BMA Swap
• LIBOR Swap

at Expiration Cash Settle Physical Settle
Considerations Forward Premium Basis Risk
VS.
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Summary of Alternatives

• MMD rate locks remove the MMD volatility from the
  pricing of Tax-Exempt Bonds (i.e., both general
  interest rates and general municipal market
  interest rates)
• The Issuer retains the risk that its bonds could
  trade at wider spreads to the general tax-exempt
  bond market than they would today and
• The Issuer would pay additional yield premium as
  compared to the BMA and 67 of LIBOR Swap rate
  locks.
• BMA and 67 of LIBOR Swap rate locks provide a
  hedge to fixed rate bonds by locking in rates on
  the BMA swap and 67 of LIBOR swap curves
  respectively.
• The Issuer retains the risk that fixed rate
  tax-exempt bonds in general could trade at wider
  spreads to the BMA swap curve and
• The Issuer also retains the risk that its bonds
  could trade at wider or narrower spreads to the
  general tax exempt bond market than they would
  today.