State and Local Financial Instruments

State and Local Financial Instruments

Policy Changes and Management

Studies in Fiscal Federalism and State–local Finance series

Craig L. Johnson, Martin J. Luby and Tima T. Moldogaziev

The ability of a nation to finance its basic infrastructure is essential to its economic well-being in the 21st century. This book covers the municipal securities market in the United States from the perspective of its primary capital financing role in a fiscal federalist system, where subnational governments are responsible for financing the nation’s essential physical infrastructure.

Chapter 9: Financial engineering

Craig L. Johnson, Martin J. Luby and Tima T. Moldogaziev

Subjects: economics and finance, public finance, politics and public policy, public administration and management, public policy


This chapter details the ways state and local governments utilize financial derivatives in conjunction with their municipal securities to manage their borrowing costs. The chapter begins by discussing financial derivatives in general and then detailing the most prevalent type of derivative used by state and local governments, the interest rate swap. It proceeds to provide a technical analysis related to the use, valuation and risks associated with interest rate swaps. It then offers some best practices for the use of financial derivatives as advocated by the Government Finance Officers Association and as informed by a case study of a municipality’s use of interest rate swaps. The chapter concludes with an overview of the impact of Dodd–Frank on the use of financial derivatives by subnational governments. Over the last couple of decades, state and local governments have increasingly engaged in financial engineering to optimize their debt management programs. Financial engineering refers to the use of mathematical analysis to develop innovative financial products or strategies to address financial challenges. One of the most popular financial engineering techniques has involved the use of financial derivatives. A financial derivative is a financial instrument whose value is derived from another asset or an index of an asset value. The most common types of financial derivatives in municipal finance include futures, forwards, options, caps, floors, collars, rate locks and interest rate swaps.

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