Derivative Instruments
5.030
C. DEFINITIONS 1. Counterparty Risk Counterparty risk is the risk that the swap counterparty will not perform pursuant to the agreement’s terms. Under a fixed payor swap, if the counterparty defaults, the University would be exposed to an unhedged variable rate bond position. The creditworthiness of the counterparty is indicated by its credit rating. The school will manage its derivative transactions to ensure that the University’s exposure to a counterparty does not exceed a proper amount. The school will consider diversifying with respect to counterparties if and when it has determined that its exposure to any counterparty is at a level above which it should not be exposed. The University will also take into strong consideration the credit ratings of the counterparty for any new Derivative Instrument as well as other appropriate security provisions in the Derivative Instruments to protect the school against counterparty risk to the greatest extent possible. 2. Termination Risk Termination Risk is the risk that the Derivative Instrument could be terminated as a result of any of several events, which may include a ratings downgrade or a counterparty covenant violation by either party, bankruptcy of either party, swap payment default by either party and other default or early termination events. The University will review potential causes of early termination, including those resulting from documentation provisions and the likelihood of credit downgrade that could precipitate an early termination. The school will use protective documentation provisions and will evaluate sources of internal liquidity and market access that could be used in the event a termination payment were required to be made. 3. Rollover Risk Rollover Risk is the risk that the term of particular Derivative Instrument is not coterminous with the related underlying debt. If a Derivative instrument is entered into to hedge interest rate risk for a specified period of time, and the University decides on the expiration date to maintain the same or a similar hedge position, it may incur re-hedging costs at that time. The school will evaluate the likelihood of the unavailability of extension or rollover of a particular Derivative Instrument based on the underlying credit of the debt, as well as the general market for Derivative Instruments. 4. Basis Risk Basis risk refers to a mismatch between the interest rate received from the swap counterparty and the interest rate actually owed on the related underlying debt. For example, the risk in a floating-to-fixed swap is that the floating rate received by the University under the swap may not at all times equal the floating rate paid by the school on the variable rate debt that it is hedging. This mismatch could occur for various reasons, including an increased supply of taxexempt securities in the marketplace, deterioration of the school’s (or credit enhancer’s) credit quality or a change in federal income tax rates for corporations and individuals. The University will measure and review the historic variation between the floating rate index used in a Derivative Instrument and the floating interest rate on the underlying debt instrument it is hedging and consider appropriate mitigation techniques as warranted. 5. Tax Risk Entities that incur tax-exempt variable rate debt inherently accept risk stemming from changes in marginal income tax rates or risk of loss of the tax-exempt status of the underlying debt. Decreases in marginal income tax rates for individuals and corporations could result in taxexempt variable rates rising faster than taxable variable rates. This is a result of the tax code’s impact on the trading value of tax-exempt bonds. This risk is also known as “tax event” ppm.5.030
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