Municipalities and their Expectations on Pay-Offs of Swap Deals

Prof. Dr. Christine Trampusch, Köln (Principal Investigator)

Dr. Agnes Orban, Köln

Florian Fastenrath, Köln

In modern financial markets swaps are used as financial tools, for instance, to manage exposure to fluctuations in interest rates. Since the mid-1980s swaps have entered the public sector, not only at the national level, but also at the sub-national level with local authorities playing the role of inventors in the use of innovative financial instruments. The crucial aspect of swap trading is that the outcomes of swap transactions occur in the future. While a swap deal might, for instance, lower interest costs or generate extra income, huge loses might also occur. In 1987, for example, the State of West Virginia lost 280 million Dollars from interest rate derivatives trading. Orange County filed for bankruptcy in 1994. In Germany, the losses of several German municipalities recently hit the head-lines. In view of these uncertainties local governments need to form expectations regarding the likely consequences of using swaps in order to make decisions. Given the tremendous growth of derivatives in the debt management of local governments, this projects seeks to provide an answer to the overarching research question: What shapes the expectations of local governments regarding swaps? More specifically, we will focus on three aspects: (1) Which expectations do local treasurers have regarding the use of swaps? (2) What shapes the expectations of public treasurers regarding the outcomes of swaps? (3) How do crises such as swap losses affect the process of forming expectations?

This project analyses the formation and change of expectations through an in-depth study of local governments’ swap activities in the U.S., U.K., and Germany between the early 1980s and 2014. Drawing upon insights from political science, behavioural economics, and economic sociology, we derive hypotheses on how cognitive mechanisms, professions, and historical experiences affect expectations. In addition to extending the social scientific state of knowledge of a largely unknown research area, the insights generated through this project will contribute to the debates about the changing state-financial-market relationship and to the development of a theory of expectation formation.