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Audit Reports Affecting Multiple Agencies

Briefing Report on Derivative Investments by Texas State Entities

Report Number 95-035

The high concentration of volatile mortgage derivatives in investment portfolios creates the risk that future liquidity problems could occur. Derivatives held by six universities and two junior colleges have market values ranging from 34 percent to over 50 percent less than book values at July 31, 1994. Odessa College has experienced liquidity problems. Five entities have more than 60 percent of their portfolios invested in mortgage derivatives, the majority of which are highly volatile. In addition, two other universities and one junior college have 34 to 44 percent of their total investment portfolios in the same types of derivatives.

Inadequate diversification of investment portfolios increases the risk that liquidity problems could occur. The lack of adequate portfolio diversification is caused by three major factors: (1) lack of good management controls over the investing function, (2) investment personnel's heavy reliance on brokers and dealers in making investment decisions, and (3) pressures on investment personnel to produce more income.

Total derivative investments account for less than 10 percent ($6.5 billion) of the total investments ($74.6 billion) of all entities reporting derivatives.

More than 92 percent of the derivative investments, or about $6 billion, are in the State's largest portfolios. The level of investment in derivatives at these entities appears reasonable in the context of their total portfolios.

Derivatives are financial instruments (security or contract) whose value is linked to, or "derived" from, changes in interest rates, currency rates, and stock and commodity prices.

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