State of North Carolina
Department of State Treasurer
RICHARD H. MOORE
State and Local Government Finance Division JANICE T.BURKE
TREASURER and the Local Government Commission DEPUTY TREASURER
October 15, 2003
To: Finance Officers of Counties, Municipalities, Boards of Education, Public Authorities,
and Certified Public Accountants
From: T. Vance Holloman, Director
Fiscal Management Section
Subject: GASB Derivatives Technical Bulletin (TB) No. 2003-1
In June of 2003, GASB issued a new technical bulletin entitled “Disclosure Requirements for Derivatives
Not Reported at Fair Value on the Statement of Net Assets.” The technical bulletin is effective for periods
ending after June 15, 2003, i.e. it will be required for the 2002-2003 financial statements. It addresses the
complicated derivatives instruments not reported at fair value including such financial contracts as
interest rate swaps, basis swaps, swaptions, interest rate caps, and commodity swaps.a These contracts are
currently held by only a small number of the larger North Carolina local governments and public
hospitals. Technical Bulletin 2003-1 supersedes the guidance issued in Technical Bulletin 94-1
“Disclosures about Derivatives and Similar Debt and Investment Transactions.” The new bulletin will
serve as authoritative guidance on the proper disclosure for these instruments until a more comprehensive
GASB project is completed addressing derivatives and hedging activities.
The objective of this new bulletin is to improve disclosures associated with derivative contracts, including
the local government’s objectives for being in the contract, the fair value, the related risks, and the effects
on future cash flows. The GASB staff has stated that the disclosures will help to clear up some of the
mystery that surrounds these transactions. It will show what the government has done; why it has done it;
the fair value of the derivative contract; and the risks the government has assumed. The definition of
derivatives has been expanded from the simple statement of “contracts whose value depends on, or
derives from, the value of an underlying asset, reference rate, or index” from TB 94-1 to a more precise
definition based on FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging
Activities.” That pronouncement sets forth three criteria that must be met for a contract to qualify as a
1. There must be the presence of an “underlying” and either a “notional amount” or a “payment
provision.” Derivative contracts derive their value from the behavior of some variable described as
the “underlying,” e.g. London Interbank Offered Rate (LIBOR), price of U.S. Treasury securities,
the price of a commodity traded on an exchange, an index of prices or rates like the Bond Market
An interest rate swap is a financial contract that effectively or synthetically converts variable-rate debt to fixed-rate debt or vice
versa. A basis swap exchanges payments based on the changes in two variable rates; e.g. payments to the counterparty based on
The Bond market Association Municipal Swap Index™ (BMA) and the payments to the unit from the counterparty based on a
percentage of LIBOR. A swaption is an option or right to execute an interest rate swap at a later time. The purchaser will pay a
premium for this privilege. An interest rate cap gives the purchaser protection against rising rates, or other indexes. A commodity
swap is where counterparties exchange cash flows that are based on a physical commodity price; it reduces the unit’s exposure to
a commodity price risk. Most commodity swaps involve oil.
325 North Salisbury Street, Raleigh, North Carolina 27603-1385
Telephone: (919) 807-2350 Fax: (919) 807-2352 Website: www.treasurer.state.nc.us
An Equal Opportunity/Affirmative Action Employer
October 15, 2003
Page 2 of 6
Association Municipal Swap Index™, or the occurrence or nonoccurrence of some specified event.
The “underlying” must be associated with a potential payment as a function of the “notional
amount,” which may also be called the face amount or the contract amount. Thus we have a
contract that provides the possibility of a payment based upon either 1) a formula in which the
“underlying” or variable is applied against the “notional amount” or 2) a trigger in which a payment
is made contingent upon the behavior of the “underlying” (variable).
2. The initial net investment, if any, must be minimal, i.e. the contract requires that the initial net
investment, if any, must be less than the notional amount (or the result of applying the notional
amount to the underlying).
3. There must be a “net settlement” provision. The contract terms must require or permit net
settlement such that one of the following conditions are met: (1) settlement does not involve actual
delivery of items associated with either the “underlying” or the “notional” amount; (2) settlement
may avoid delivery by selling the contract, entering into an offsetting contract, or converting the
exchanged asset into cash; or (3) settlement involves the delivery of another derivative, e.g. a
“swaption” calls for the delivery of a swap contract.
This more comprehensive definition provides additional clarification of these complicated instruments
and will assist in the preparation of comparable disclosures.
The disclosures mandated by the new technical bulletin cover those derivatives, held as of year-end, not
presented in the financial statements at fair value. (Investment derivatives reported at fair value are
covered by other GASB pronouncements, such as statements 31 and 40). The disclosure requirements
address five areas of information: objectives, significant terms, fair value, risks, and associated debt. The
objectives section of the note disclosure pertains to why the unit has entered into the derivative providing
the context necessary to explain the instrument and the unit’s strategies for using derivatives. For larger
North Carolina local governments, the typical derivative will be an interest rate swap where the use of the
derivative is to lower borrowing cost. The terms of the derivative that must be included are the “notional “
or face/contract amount, the interest rates (including caps, floors, and collars), any embedded options (call
provisions), effective date, and the date when it is scheduled to mature or terminate. The fair value of the
instrument must be disclosed and if quoted market prices are not available, the method used for
calculation and any significant assumptions must also be included.b Local governments are asked to
discuss the different types of risks to which the unit may be subject while holding the derivative contract.
The list includes credit risk, interest rate risk, basis risk, termination risk, market access risk, and rollover
“Credit risk is the risk that a counterparty will not fulfill its obligations.” There are five related
disclosures for credit risk: credit quality ratings of the counterparties; maximum amount of loss
(excluding collateral or other security) based on the fair value of the derivative at year-end;
description of collateral or other security that supports the contract and discussion of the
government’s access to said collateral; information on any master netting arrangements between
parties to mitigate credit risk; and the extent of diversification between counterparties.
“Interest rate risk is the risk that changes in interest rates will adversely affect the fair value of the
government’s financial instruments or a government’s cash flows,” i.e. the risk that loss will arise
from changes in the market. All relevant facts and terms should be included in the disclosure.
If no quoted market prices are available, fair value can be based on discounted future cash flows calculated using the zero-
coupon method, the par-value method or the options pricing models.
October 15, 2003
Page 3 of 6
“Basis risk is the risk that arises when variable interest rates on a derivative and an associated bond
or other interest-paying financial instrument are based on different indexes.” When different
indexes are used, there is the possibility that the relationship between indexes will change such that
projected cost savings or synthetic interest rates may not be realized.
“Termination risk is the risk that a derivative’s unscheduled end will affect the government’s asset/
liability strategy or will present the government with potentially significant unscheduled
termination payments to the counterparty.” If termination risk is present, the unit must disclose
(1) any termination events that have occurred; (2) dates that a derivative may be terminated; and
(3) out-of-the-ordinary termination events contained in the contracts.
“Rollover risk is the risk that a derivative associated with a government’s debt does not extend to
the maturity of that debt.” In other words, rollover risk arises when the term of the derivative is
shorter than the term of the government’s corresponding debt thereby creating a gap in the
protection otherwise provided by the derivative. If rollover risk is present, the unit must disclose it
and indicate the maturity of the derivative and the maturity of the associated debt.
“Market-access risk is the risk that a government will not be able to enter credit markets or that
credit will become more costly.” This type of risk arises when a unit enters into a derivative in
anticipation of entering the credit market at a later time but is subsequently prevented from doing
so, compromising the objective of the derivative.
Only those risks actually faced by the local government must be disclosed. These risk disclosures are to
be presented in the context of each derivative; i.e. information presented elsewhere in the statements in
some other context must be cross-referenced or repeated as part of this disclosure. When the objective of
entering into a derivative is to lower interest cost by creating a synthetic interest rate, the unit must also
disclose in a debt service table the derivative’s net cash flow and the debt service requirements of the
Typically the application of this technical bulletin for North Carolina governments will apply to interest
rate swaps. Statutory authority derives from the financing statutes therefore these instruments cannot be
used for investment purposes. New legislation from the 2003 summer session (Senate bill 679) clarifies
the statutes to specifically allow governments to participate in interest rate swaps with LGC approval.
Many factors are considered for the LGC to approve entry into an interest rate swap agreement including
a unit’s credit rating. Purchasing contracts with certain conditions may also meet the definition of a
derivative. Commodity swaps, which require disclosure in the bulletin, are not allowable for local
governments under North Carolina law.
Units will often enter into contracts for the purchase or sale of products such as electric power or natural
gas. “Normal purchase and normal sale” contracts for such products are exempted from the reporting
requirements of the Technical Bulletin if the contracts are for a quantity of the product that is expected to
be used over a reasonable period in the normal course of business. Contracts such as forward, futures,
and option contracts for such products may not qualify as normal sales or purchases depending upon the
provisions of the contract.
Forward contracts, contracts to buy or sale a reasonable quantity of a product in the future to manage
price fluctuations and including an expected delivery appear to be allowable under the statutes. Any such
forward contract with a net settlement provision may or may not qualify as a “normal purchase or normal
sale contracts” under the derivatives definition in the Bulletin. A net settlement provision would exist in a
contract if delivery of the product is not required, the contract may be settled by other means such as a
cash payment, or one party is required to deliver the product but a market exists that would enable them to
sell the contract or enter into another offsetting contract. A contract that calls for a cash settlement of
October 15, 2003
Page 4 of 6
gains or losses on the contract at set dates is not eligible for the exception under the Bulletin and would
require disclosure as a derivative. The only circumstances under which a forward contract with a net
settlement provision could be eligible for the exception would be if it were probable that the contract will
result in delivery of the product. If delivery is not highly probable, the forward contract would be defined
as a derivative and the relevant criteria as previously discussed must be disclosed.
An option contract that requires the delivery of goods at a contract price only when exercised would not
qualify for the exception thereby requiring disclosure. A forward contract that contains an option would
qualify for the exception if the conditions for the exception in the previous paragraph are met and the
option does not modify the quantity of goods to be delivered under the contract. The forward contract
could also qualify if the option clause modifies the quantity of the product to be delivered, but the
additional goods would be bought and sold at market value as of the delivery date.
Due to the complexity of these contracts, units should contact legal counsel regarding the statutory
authority to be in such contracts. Contracts for fuel, oil and natural gas are subject to the informal bidding
requirements. Forward, futures and option contracts for quantities beyond reasonable need or without
expected delivery that function like investments are not allowable pursuant to G.S. 159-30.
Contracts for the purchase or sale of electric power that do not meet the definition of a “normal purchase
or normal sales” contract would qualify for the exception if it is a capacity contract. Under a capacity
contract one party sells their ability to deliver power to the electric transmission system of an operating
control area to another party so that party can meet their obligations to deliver power. This is true for a
forward contract, an option contract or a forward contract that contains an option. Arrangements for
purchasing power for ElectriCities as members of one of the power agencies are not affected by this
Any contract whose price is based upon an index not related to the good, such as a stock price index,
would not qualify for the exception.
Units should document in their files the reasons for concluding that a contract qualifies for the “normal
purchase and normal sales” exception to the reporting requirements of this Technical Bulletin. If a
contract does not qualify for the exception, the disclosure requirements of TB 2003-1 must be met as
previously discussed. Any disclosures for contracts that qualify under the TB requirements should be
placed in the commitments section of the note disclosures.
Derivatives are extremely complicated financial contracts. Attached to this memo is an example of a note
disclosure for an interest rate swap demonstrating variable-rate debt swapped for fixed-rate debt. For
some of the information in the disclosure, your counterparty will need to provide the data. For further
clarification, please see the actual text of Technical Bulletin 2003-1, or FASB Statement No.133. If you
have questions, call Sara Shippee of our office at 919-807-2356.
October 15, 2003
Page 5 of 6
Sample note disclosure
Interest rate swap … (to be included in the debt section of the note disclosures)
Objective of the interest rate swap. As a means to lower its borrowing costs and increase its savings, when
compared against fixed-rate refunding bonds at the time of issuance in December 2002, the County entered
into an interest rate swap in connection with its $40,000,000 Variable Rate General Obligation Refunding
Bonds, Series 2002. The intention of the swap agreement was to effectively change the County’s interest rate
on the bonds to a synthetic fixed rate of 3.0%. For comparison, the County sold fixed rate bonds on the same
day as the swap, with the same maturity, at an interest rate of 4.4516%.*
Terms. The bonds and the related swap agreement mature on June 1, 2023 and the swap’s notional amount
of $40,000,000 matches the $40,000,000 million variable-rate bonds. The swap was entered into at the same
time the bonds were issued, (December 2002.) Starting in fiscal year 2004 the notional value of the swap and
the principal amount of the associated debt decline. Under the swap the County pays the counterparty a fixed
payment of 3.0% and receives a variable payment computed at 67 percent of the London Interbank Offered
Rate (LIBOR). Conversely, the bonds’ variable-rate coupons are associated with the Bond Market
Association Municipal Swap Index™ (BMA).
Fair value. Because interest rates have declined since execution of the swap, the swap has a negative fair
value of $1,500,000 as of June 30, 2003. The swap’s negative fair value may be countered by a reduction in
total interest payments required under the variable rate bonds, creating a lower synthetic interest rate.
Because the coupons on the County’s variable-rate bonds are adjusted every seven days to changing interest
rates, the bonds do not have a corresponding fair value increase. The mark-to-market valuations were
established by market quotations from the counterparty representing estimates of the amounts that would be
paid for replacement transactions.
Credit risk. As of June 30, 2003 the County was not exposed to credit risk because the swap had a negative
fair value. However, should interest rates change and the fair value of the swap become positive, the County
would be exposed to credit risk in the amount of the derivative’s fair value. The swap counterparty was rated
Aa1 by Moody’s Investors Service (Moody’s), AA- by Standard and Poor’s (S&P) and AA by Fitch Ratings
(Fitch). To mitigate the potential for credit risk, if the counterparty’s credit quality falls to A1 by Moody’s or
A+ by either S&P or Fitch and their exposure exceeds $5,000,000 the fair value of the swap will be fully
collateralized by the counterparty with U.S. government securities. Collateral would be posted with a third
Note to preparer: It may be that for future swaps, local governments will also be required to put up collateral to be
held by a third party custodian to offset risks to the counterparty. This condition would need to be included.
Basis risk. The swap exposes the County to basis risk should the relationship between LIBOR and BMA
converge, changing the synthetic rate on the bonds. The effect of this difference in basis is indicated by the
difference between the intended synthetic rates of 3.0% and the synthetic rate as of June 30, 2003 of 3.17%.
As of June 30, 2003, the rate on the County’s Bonds was 0.92%, whereas 67 percent of LIBOR was
Note to preparer - Assumptions: Fixed rate to counterparty 3.0000
Variable rate from counterparty .7504
Variable rate bond coupons .9200
Synthetic rate on bonds at 6/30 3.1696
October 15, 2003
Page 6 of 6
Termination risk: The County or the counterparty may terminate the swap if the other party fails to perform
under the terms of the contract. An additional termination event occurs if the counterparty ratings fall below
Baa1 (Moodys) or BBB+ (S&P and Fitch) by at least two of the rating agencies. The swap may be
terminated by the County with 30 days notice and the counterparty can only terminate the swap if the County
falls below BBB- with any of the three major rating services. Also, if at the time of termination the swap has
a negative fair value, the County would be liable to the counterparty for a payment equal to the swap’s fair
Note to preparer: Rollover risk, the risk that the maturity of the swap agreement does not match the maturity of the
unit’s debt issue, and market-access risk, the risk that the unit would not be able to enter the credit market or that
debt would be more costly at that time, would not have to be discussed unless the maturity of the swap agreement
differs from the maturity of the associated debt issue. Currently the LGC is not allowing different maturities.
Swap payments and associated debt. Using rates of June 30, 2003 debt service requirements of the
variable-rate debt and net swap payments, assuming current interest rates remain the same for the term of the
bonds, were as follows. As rates vary, variable-rate bond interest payments and net swap payments will vary.
As indicated in the derivatives note, the initial synthetic fixed interest rate lowers the County’s interest cost
by over 26% compared with the issuance of fixed-rate debt .*
Fiscal Year Variable-Rate Bond Interest Rate
Ending June 30 Principal Interest Swap, Net Total
2003 $ $ 184,000 $ 449,920 $ 633,920
2004 2,000,000 368,000 899,840 3,267,840
2005 2,000,000 349,600 854,848 3,204,448
2006 2,000,000 331,200 809,856 3,141,056
2007 2,000,000 312,800 764,864 3,077,664
2008-2012 10,000,000 1,288,000 3,149,440 14,437,440
2013-2017 10,000,000 828,000 2,024,640 12,852,640
2018-2022 10,000,000 368,000 899,840 11,267,840
2023 2,000,000 18,400 44,992 2,063,392
Total $40,000,000 $4,048,000 $9,898,240 $53,946,240
Note to preparer: Interest Rate Swap, Net = swap fixed rate less 67% LIBOR times the outstanding principal
(LIBOR = 1.12 at June 30, 2003 x 67% = .007504)
(.03 - .007504) x 40,000,000 = 899,840)
* The statements within the disclosure that appear in italics are “optional” statements to clarify the
objectives and advantages of entering into the swap agreement. If the unit sold other debt within a similar
timeframe and for a similar maturity, the transaction can provide comparative data that may enhance the
argument for entering into the swap agreement. Technical Bulletin 2003-1 does not require these statements.