State of Connecticut

Notes to the Financial Statements

June 30, 2010

Note 19 Derivative Financial Instruments

The fair value balances and notional amounts of the State's derivative instruments outstanding at June 30, 2010, classified by type, and the changes in fair value of such derivative instruments for the year then ended are as follows (amounts in thousands; debit(credit)):

   Changes in Fair Value    Fair Value at Year End
   Classification    Amount    Classification    Amount    Notional
Governmental activities               
Cash flow hedges:               
Pay-fixed interest   Other Non-current     Non-current portion of LT      
rate swap   Assets   (6,804)   Obligations   (27,817)   355,620
Business-type activities               
Cash flow hedges:               
Bradley Airport:            
Pay-fixed interest   Other Non-current  Non-current portion of LT      
rate swap   Assets   (8,542)   Obligations   (16,747)   152,380

Objective and Terms of Hedging Derivative Instruments
The following table displays the objective and the terms of the States' hedging derivative instruments outstanding at June 30, 2010, along with the credit rating of the associated counterparty (amounts in thousands). 

     Notional        
      Amounts    Effective    Maturity       Counterparty
Type   Objective    (000's)    Date    Date    Terms    Credit Rating
Pay-fixed interest rate swap   Hedge of changes in cash flows of the 2001 GO bonds   $20,000   6/28/2001   6/15/2012   Pay 4.33% receive CPI plus 1.43%   A/A/A
Pay-fixed interest rate swap    Hedge of changes in cash flows of the 2005 GO bonds    140,000    3/24/2005    3/1/2023    Pay 3.392% receive 60% of LIBOR+30bp    Aa/AAA/nr
Pay-fixed interest rate swap    Hedge of changes in cash flows of the 2005 GO bonds    140,000    3/24/2005    3/1/2023    Pay 3.401% receive 60% of LIBOR+30bp    Aa/A/nr
Pay-fixed interest rate swap    Hedge of changes in cash flows of the 2005 GO bonds    15,620    4/27/2005    6/1/2016    Pay 3.99% receive CPI plus .65%    A/A/A
Pay-fixed interest rate swap    Hedge of changes in cash flows of the 2005 GO bonds    20,000    4/27/2005    6/1/2017    Pay 5.07% receive CPI plus 1.73%    A/A/A
Pay-fixed interest rate swap    Hedge of changes in cash flows of the 2005 GO bonds    20,000    4/27/2005    6/1/2020    Pay 5.2% receive CPI plus 1.79%    Aa/AA/AA
   Total Notional Amount    $355,620        

The fair values of interest rate swaps were estimated using the zero-coupon method. This method calculates the future net settlement payment required under the swaps, assuming that the current forward rates implied by the yield curve correctly anticipate future spot interest rates. These payments are then discounted using the spot rates implied by
the current yield curve for hypothetical zero-coupon bonds due on the date each future net settlement on the swaps.

Credit Risk
As of June 30, 2010, the State had no credit risk exposure on any of the swaps because the swaps had negative fair value. However, should interest rates change and the fair values of the swaps become positive, the State would be exposed to credit risk in the amount of the swaps’ fair value.

Interest Rate Risk
The State is exposed to interest rate risk on its interest rate swaps. As the LIBOR or CPI swap index rate decreases, the State's net payment on the swap increases.

Basis Risk
The State's variable-rate bond interest payments are based on the Securities Industry and Financial Markets Association Municipal Swap (SIFMA) index rate, or the CPI floating rate. The State is exposed to basis risk on those swaps for which the State receives variable-rate payments that are based on the LIBOR swap index rate. As of June 30, 2010, the SIFMA rate was 0.25 percent, whereas 60 percent of LIBOR plus 30bp was 0.509 percent. The State recognizes this basis risk by including an amount for basis risk in its debt service budget. For fiscal year 2010, the budgeted amount for basis risk was $1,500,000.

Termination Risk
The State or the counterparty may terminate any of the swaps if the other party fails to perform under the terms of the contract. If any swap is terminated, the associated variable-rate bonds would no longer carry synthetic interest rates. Also, if at the time of termination the swap has a negative fair value, the State would be liable to the counterparty for a payment equal to the swap's fair value. Under the 2005 swap agreements, the State has up to 270 days to fund any required termination payment.

Rollover Risk
Because all of the swap agreements terminate when the associated debt is fully paid, the State is only exposed to rollover risk if an early termination occurs. Upon an early termination, the State will not realize the synthetic rate offered by the swaps on the underlying debt issues.

Hedging Derivative Instrument Payments and Hedged Debt
As rates vary, variable-rate bond interest payments and net swap payments will vary. Using rates as of June 30, 2010, debt service requirements of the State's outstanding variable-rate bonds and net swap payments are as follows (amounts in thousands).

Fiscal Year    Variable-Rate Bonds    Interest Rate
Ending June 30,    Principal    Interest    SWAP, Net    Total
2011    $-    $1,777    $10,833    $12,610
2012    20,000    1,778    10,832    32,610
2013    -    1,170    10,575    11,745
2014    -    1,170    10,575    11,745
2015    -    1,751    16,804    18,555
2016-2020    260,620    3,492    28,918    293,030
2021-2023    75,000    337    2,780    78,117
Total    $355,620    $11,475    $91,317    $458,412

As of June 30, 2010, Bradley airport has entered into interest rate swap agreements for $152.4 million of its variable rate bonds. Details on these agreements are disclosed under the separately issued audited financial statements of the fund.