The State of Connecticut Municipal Swap
1.Analyze
the structure of the variable rate debt described in the case (UPDATES, VRDOs,
etc.). ?(a) Explain the put, call and cap features and their respective
importance. ?(b) At what rate should this debt trade? Do you agree with Merrill
Lynch’s assessment of J.J. Kenny minus 55bpts? How did Merrill arrive at this
rate?
2.Compare
three forms of debt - fixed rate debt, floating rate debt (with JJK, say) - and
explain for each what risks the issuer and investor bear, respectively.
3.Analyze
the fixed rate alternatives as proposed by Bankers’ Trust and Merrill Lynch.
Which one is more favorable for the State of Connecticut?
4.Analyze
the State of Connecticut’s alternatives including a fixed for LIBOR (one or
three months) swap with AIG. Assume AIG will quote the rates given in Exhibit 1
of the case. Which one would you recommend?
5.What part
of the analysis could benefit from explicit term structure modelling? How would
you use a (statistical) model of the term structure of interest rates? What
additional infor- mation could be gained, what are possible disadvantages?
6.How
useful are synthetic fixed-rate debt instruments in your opinion? Why would
anybody want to construct such instruments? What are their advantages and
disadvantages?
Please note the following ground rules for the case
write-ups:
•the
maximal group size is 5; every group member receives the same grade;
•at most 2
pages of analysis and 6 pages of technical appendices;
•show your
work, staple the pages together and be professional;
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Rev. December 20, 1994
State of Connecticut Municipal Swap
In May 1990, Benson R. ("Bud") Cohn, Assistant Treasurer-Debt Management for the State of
Connecticut, was considering how best to raise $325 million in tax-exempt, twenty-year fixed-rate
debt. The funds were needed for the state's capital spending program. On his desk were competing
proposals from Merrill Lynch Capital Markets and BT Securities (a wholly-owned subsidiary of
Bankers Trust New York Corporation). The proposals each contained a "synthetic" alternative to
straight fixed-rate debt which involved pairing a long-term variable-rate bond issue with an interest
rate swap. Depending on the assumptions, it seemed the synthetic approach could save the state 50
basis points or more in financing costs. The market for municipal interest rate swaps was nascent, but
growing. If executed, the proposed swap would be the first for the state and the largest to date in the
municipal market. Before he could go this route, however, Bud Cohn wanted to satisfy himself not
only that the cost savings were real, but also that the transaction was not unduly risky.
Financing the State of Connecticut
Connecticut was first settled in 1633 and was the fifth state to ratify the U.S. Constitution in
1788. In 1990, the State's population exceeded 3.2 million; three metropolitan areas, Hartford,
Bridgeport and New Haven, accounted for 84% of the total. During the 1970s and 1980s, state
population growth was slow. The economy was diversified between aerospace/defense (primarily
aircraft engines, helicopters, and submarines), services (primarily insurance) and trade. Per-capita
income, at $25,000, was 40% higher than for the nation as a whole. The 1990 state general funds
budget totaled almost $6.4 billion and the capital budget came to almost $1.7 billion.
Connecticut first issued bonds in the eighteenth century. In recent years, it has ranked...