Investors aren't the only ones

who can benefit from

customizing derivatives. Creative issuers

can combine various products to

better meet their needs, too.

A basic interest rate swap, for

example, has a stated maturity

when the


of interest




side can


the swap



but that

requires a termination payment

that cannot be predicted in


An issuer using such a swap in

combination with variable-rate

bonds generates debt service

savings compared with a fixed-rate

bond issue. But the issuer loses

one of the basic benefits of

issuing ordinary debt: the ability to

call the bonds early.

If rates decline after bonds are

issued, a typical issuer can

refund or advance refund bonds.

Even if rates later rise, the issuer

has locked in lower debt service

with the refinancing deal.

But issuers that use a swap and

variable-rate bonds cannot lower

debt service without terminating

the swap early, and that can be


For example, an issuer might

sell 30-year, floating-rate bonds

that pay an initial rate of interest

linked to the Public Securities

Association's municipal swap

index, about 2.45% this week. The

issuer enters a swap and pays a

fixed rate of 6.00%. The swap

counterparty pays the issuer a

floating rate based on the PSA


But if there is a decline in

interest rates, including the PSA

rate, the 6.00% rate paid by the

issuer is now above-market.

Even if the issuer can call the

bonds, it still must pay the fixed

rate on the swap. And because

the issuer is paying an

abovemarket rate to the swap

counterparty, it probably would have to

make a substantial termination

payment to escape.

Instead, the issuer could use a

modified swap that includes a

call provision. On a callable

swap, the issuer can terminate

the transaction early without

having to compensate the


But in return for granting the

issuer a call right, the swap

counterparty might require an

upfront payment or a higher fixed

rate. And since the issuer is

comparing the cost of the swap

transaction with the cost of a fixed-rate

bond deal, the added expense may

make the swap uneconomical.

The cost of the call option varies

according to a number of market

factors. Volatility is a significant

component of the price. The value of

options generally rises as volatility


In a calm market, the cost of

including the option would usually be

lower than in a volatile market.

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