With interest rates unsettled and most of the market away for the Thanksgiving holiday, the small amount of derivatives action within the last week was dominated by forward swaps activity. But heavy bond issuance in upcoming weeks could provide fertile ground for embedded derivatives in the primary market.

Birmingham, Ala., plans this month to use a forward swap agreement to effectively refund debt that cannot be advance refunded. The city has agreed to issue $75 million of variable-rate general obligation debt in 1997 and, simultaneously, enter an interest rate swap. The transactions, which will occur when existing debt can be refunded, together create a synthetic fixed rate for the city.

Although the swap will not commence until 1997, the city next month will lock in the fixed rate that it will pay on the swap. The terms will be slightly less favorable to the city than if the swap began immediately.

Morgan Stanley & Co. will sell the bonds. Societe Generale will provide a letter of credit backing the bonds and will be the city's swap counterparty. The bonds will carry insurance from AMBAC Indemnity Corp. The bonds will in 2015 and the swap contract and the LOC will expire the same year.

The transaction has not closed yet and officials at firms working on the deal declined to comment.

Today's $1.3 billion competitive note sale by New Jersey could include derivatives. The state will accept bids for up $1 billion of the notes structured as variable rate demand obligations, carrying put rights and liquidity enhancement from Credit Suisse and Swiss Bank. The state will also accept bids for up $250 million of the notes structured as index-based variable-rate notes.

Derivatives professionals said they have seen an increasing number of issuers ask for separate proposals on derivatives when bringing big deals to market. The New York Thruway Authority, for example, has asked underwriters to make separate "requests for proposals" on derivatives for its upcoming deal.

Regulators continue to focus on the derivatives market. Federal Reserve Governor Susan Phillips, speaking yesterday on CNBC, discussed recent reports assessing the state of the market.

She said that firms entering the derivatives area "should go in fairly slowly," stressing that she had not seen firms rushing in recklessly. "I have not seen that kind of precipice approaching. But certainly a word of caution is advised," she said.

Phillips also suggested that derivatives dealers that have entered transactions with Japanese banks may need to set aside additional reserves for the transactions. The plummeting Japanese stock market puts the credit of the Japanese banks at risk because many of the banks have a significant portion of their assets in stocks.

Phillips said economic problems in Japan and among Japanese banks also spring from over-valued real estate.

In other news, Westpac Banking Corp. has created a triple-A-rated, stand-alone derivatives subsidiary. The Australia-based bank was a major player in derivatives until January, when it was downgraded to single-A status, market sources said.

The separately capitalized subsidiary will act as a derivatives counterparty for the bank's clients who desire a higher rated partner.

The subsidiary, called Westpac Derivative Products Ltd., will be capitalized with $100 million from the parent bank and a $ 1 00 million surety bond from Capital Markets Assurance Corp.

Only five firms have set up such triple-A rated subsidiaries. Merrill Lynch & Co., Goldman, Sachs & Co., Salomon Brothers, and Compagnie Financiere de Paribas have previously set up derivatives subsidiaries.

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