06-20-07 FPAC Minutes - Laserfiche WebLink

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GFOA Recommended Practice • Use of Derivatives by State and Local Governments for Cash Operating and Reserve Portfolios(1994 and 2002) Background. Derivative products are financial instruments created from or whose value depends on (is derived from) the value of one or more underlying assets or indexes of asset values. Derivatives include instruments or features such as collateralized mortgage obligations (CMOs), interest-only (IOs) and principal-only (POs) securities, forwards, futures, currency and interest rate swaps, options, floaters/inverse floaters, and caps/floors/collars. It still remains the responsibility of each government to determine what constitutes a derivative product and what is allowable by policy and statute. Recommendation. The Government Finance Officers Association (GFOA) urges state and local government finance officers to exercise extreme caution in the use of derivatives and to consider their use only when they have developed a sufficient understanding of the products and the expertise to manage them. Because new derivative products are increasingly complex, state and local governments should use these instruments only if they can evaluate the following factors, among others, to determine their appropriateness: 1. Governmental entities must observe the objectives of sound asset and liability management policies that ensure safety, liquidity, and yield within legally allowable investments. Because of the risks involved, the use of derivatives by governmental entities should receive particular scrutiny. Certain derivative products may not be appropriate for all governmental investors. Characteristics of such products can • include high price volatility, illiquid markets, products that are not market-tested, highly leveraged products, products requiring a high degree of sophistication to manage, and products that are difficult to value. 2. Governmental entities should understand that state and local laws may not specifically address the use of derivatives and examine such considerations as • the constitutional and statutory authority of the governmental entity to execute derivative contracts, • the potential for violating constitutional or statutory provisions limiting the entity's authority to incur debt resulting from the transaction, and • the application of the governmental entity's procurement statutes to derivative transactions. 3. Governmental entities should be aware of all the risks associated with use of derivatives, including counterparty credit, custodial, market, settlement, and operating risk. 4. Governmental entities should establish internal controls for each type of derivative in use to ensure that these risks are adequately managed. For example, • the entity should provide a written statement of purpose and objectives for derivative use; • written procedures should be established that provide for periodic monitoring of derivative instruments; •