TRS 2011 Comprehensive Annual Financial Report

TEACHER RETIREMENT SYSTEM OF TEXAS COMPREHENSIVE ANNUAL FINANCIAL REPORT 2011
Notes to the Financial Statements
F. DERIVATIVES
The fair value balances and notional amounts of investment derivative instruments outstanding at August 31, 2011, classified by
type, and the changes in fair value of such investment derivative instruments for the fiscal year ended August 31, 2011 are as follows.
Fiduciary Funds
Investment Derivatives:
Changes in Fair Value Fair Value at August 31, 2011
Classification Amount Classification Amount Notional
Gain/(Loss)
Forward Contracts Investment Revenue $ (49,953,250) Investment $ (27,320,899) $11,619,782,632
Futures Contracts Investment Revenue $ 220,711,897 Investment $ -0- $14,149,497,819
Swap Contracts Investment Revenue $ 1,750,131,755 Investment $ (66,049,055) $ 6,062,787,733
Warrants Investment Revenue $ 881,051 Investment $ 103,840 $ 355,247
The methods and significant assumptions used to estimate fair value of the system’s investment derivative instruments are presented
in Note 1. Summary of Significant Accounting Policies, Section F. Assets, Liabilities and Legal Reserves.
Derivatives are financial instruments the value of which are derived, in whole or part, from the value of any one or more underlying
securities or assets, or index of securities or assets (such as bonds, stocks, financial commodities, and currencies). Derivatives include
futures contracts, options, options on futures contracts, forward contracts, swap contracts, and any instrument or contract intended to
manage transaction or currency exchange risk in purchasing, selling or holding investments.
The system’s investment policy states that derivatives may only be used to efficiently manage and reduce the risk of the overall
investment portfolio in accordance with applicable law, and must comply with the fiduciary standard of prudence set forth in the Texas
Constitution, Article XVI, Section 67(a)(3). Consistent with these objectives, derivative applications may be used to implement investment
strategies in a lower cost and efficient manner; efficiently manage the fund’s portfolio by altering the portfolio’s market exposure in
lieu of trading the underlying cash market securities through purchases or short sales, or both, of appropriate derivatives; construct
portfolios with risk and return characteristics that could not be created with cash market securities consistently with the objectives in
the investment policy and in compliance with applicable law; hedge and control risks so that the fund’s risk-return profile is more closely
aligned with the fund’s targeted risk-return profile through purchases or short sales, or both, of appropriate derivatives; and facilitate
transition trading when holdings must be rebalanced or reallocated among permissible investments as a result of changes to applicable
benchmark indexes or investment policy changes. Derivatives may not be used for any activity a primary purpose of which is speculation
or to profit while materially increasing risk to the system. The tenor of interest rate over-the-counter swaps may not exceed thirty years
or shorter based on market liquidity. The tenor of all other over-the-counter derivative instruments may not exceed five years. Derivative
applications may not be used to invest in asset classes that are not consistent with the system’s legally permissible and policy asset
categories, implementation strategies, and risk-return characteristics. Derivatives underlain by physical commodities may only be made
through investments in funds that issue securities or other structures that also provide limited liability or limited risk of loss to investors.
Investments in cash settled derivatives which reference commodities are permitted.
Any counterparty to an over-the-counter derivative transaction must have a credit rating of at least A- (Standard & Poors or Fitch)
or A3 (Moody’s) and is subject to established ISDA Master Agreements. All ISDA Master Agreements provide that netting applies. The
system and external managers may also use collateral arrangements to mitigate counterparty credit or performance risk. The net market
value of all over-the-counter derivative positions, less collateral posted, for any individual counterparty may not exceed $500 million.
Forward Contracts
A forward contract is a non-standardized contract for the physical or electronic (through a bookkeeping entry) delivery of a commodity
or financial instrument at a specified price at some point in the future.
Futures Contracts
A futures contract is a commitment to buy or sell a specified quantity of a commodity or financial instrument at a specified price
with payment and delivery occurring at a specified future date. Futures contracts are used primarily as a tool to increase or decrease
market exposure to various asset classes.
Swap Contracts
The system’s swap contracts are a bilateral financial contract in that the parties agree to exchange cash flows of defined investment
assets in amounts and times specified by the contract. Swap transactions are used to efficiently manage or reduce the risk of the overall
investment portfolio, or both. An interest rate swap is structured such that one stream of future interest payments is exchanged for
another based on the notional amount. A total return swap is structured such that the total return (cash flows plus capital appreciation/
FINANCIAL SECTION
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