*"I've seen things in the market where I scratch my head and can't imagine why people did it. For example, when P&G lost all that money, I couldn't fathom what anyone at the company was thinking when they looked at the formula of that swap and said "Yes, that's exactly what I want to put on." - Confessions of a Structured Note Salesman.*

On November 1992, Procter and Gamble (P&G) and Banker's Trust entered a five year interest rate swap contract (called '

*5/30'*), with semiannual payments, on a $200 million notional amount. Interest Rate Swaps are the most diffused and heavily traded financial products whose notional amount outstanding corresponded to $347 trillion in 2012, according to the Bank for International Settlements (BIS). P&G wanted to reduce their annual interest expenses ($500 million) by $100 million. Companies as big as P&G are exposed to foreign exchange and interest rate risk as they operate worldwide. Compared to other derivatives disasters, P&G ended up losing

**only $157 million**, lowering their earnings per share by 0.15 cents. Why was this such a big event if the loss was so 'small'? First of all, it was the first case of a derivatives transaction ruled by a judge (1996). Second, it raised concerns over accounting reforms for corporate disclosures

*(see later in the post)*. Third, it gave us a glance of the behind-the-scene world of investment banking.

The structure was pretty much standard although it was based on a

*bizarre*formula. P&G paid a floating interest rate in exchange for a fixed one. P&G was short the swap. The fixed interest rate was 5.30%; the floating one was set as the following:

*.*

__30-day Commercial Paper Daily Average Rate - 75 basis points (as a premium for P&G) + a__**spread**
The

**spread**was calculated according to the following formula:
The

*5-year CMT*is the yield on the five-year constant maturity Treasury Notes, the*30-year treasury (TSY) price*is the price for the 30 year T-bond maturing in August 2023.
This contract is particular and one of its kind as it has several interesting features:

1) It does not use what is conventionally used as the standard floating rate, that is the LIBOR rate;

2) The source of leverage is the spread;

3) It relates short term and long term interest rates (through the 30-year TSY price) in an inverse relation;

4) The spread for the first semiannual payment was set to 0;

5) The other 9 semiannual payments (out of 5 years) were fixed on the interest rates a specific date (May 4, 1994).

The

__key components__in the swap contract are:
- The 30-day Commercial Paper Daily

*Rate***Average***(like an Asian product**),*not the specific rate at a certain day;
- If the spread was 0, P&G would have paid 75 basis points minus the CP rate;

- The higher the 5-year CMT interest rate, the lower the 30-year TSY price (as the interest rate on this security goes up), the higher the spread in the formula is.

P&G was betting on interest rates to remain stable over the next five years (that is the spread to be ~0). If so, P&G would have paid 75 basis points minus the CP rate and saved some money in interest payments (its original goal). But...but...but...it didn't happen!

**In fact, the FED in February 1994 tightened its monetary policies pushing yields up:**

*5-year Treasury CMT moved from 5% to 6.73%.*

*30-year Treasury Rate moved from 6.12% to 7.40%.*

Was it difficult for P&G to see how its position moved as interest rates did? NO, not at all

**.**They could have formulated different scenarios, calculating the spread for different interest rates moves.
Let's see this point through 2 examples:

1) Assuming a 5.02% interest rate on CP and a 6.06% yield to maturity on the 30-year Treasury bond (equivalent to a price of $102.58):

The spread in this case would be 0 as it is negative. In this example, interest rate are chosen to be low. P&G would have to pay the

__30-day Commercial Paper Daily Average Rate - 75 bp.__
2) Let's try now with high interest rates: assuming a 6.71% interest rate on CP and a 7.35% yield to maturity on the 30-year Treasury bond (equivalent to a price of $86.84):

The spread in this case is equivalent to 2750 basis points or 27.50%! P&G would have to pay:

*30-day Commercial Paper Daily Average Rate**- 75 bp + 2675 bp!*
By simply using an Excel spreadsheet, Smith (1997) calculated the magnitude of the spread according to several interest rate moves. P&G could have done so, before it entered the swap contract, to have a better idea of what could have happened:

*Multiply the values by 100 to get the spread in percentage terms. For example, a 6.50% on the 30-year Treasury Yield with a 6.75% 5-year yield would have costed P&G 1830 basis points or 18.3%.*

P&G entered an over-the-counter product with Bankers' Trust. Why do firms prefer OTC products over products traded on exchanges? The benefits are mainly three:

- Liquidity,

*because...*
- No margin is required (when the parties enter the contract a/o for entire settlement period)

*and...*
- Securities are not marketed to market (MTM);

- Accounting benefits;

P&G preferred an OTC product because of favorable accounting treatments: the transaction could have been amortized over 5 years, with deferred income and expenses. The contract itself was regarded by the accounting standards as an hedge and not as speculation (as written options are).

It is important to understand

__how market participants use derivatives,__which seems to be the real problem and key player in disaster. And the next question is: should corporate treasuries behave as profit centers? P&G was**. In each of the three cases I specifically talked about (see here and here), the inappropriate behavior of one or more parties involved played a prominent role in the disaster. Also, the***speculating*__level of expertise__of the parties is important as well as the supervision of the__risk management system__. To conclude, investors should primarily prefer vanilla products over complicated ones. If you can't understand the structure of a product,__avoid it__. It may sound obvious but when we look back at these derivatives disasters*"you scratch your head and can't imagine why people did it."*

*References:*

*Donald J. Smith (1997) - Aggressive Corporate Finance:*

*A Close Look at the Procter & Gamble-Bankers Trust Leveraged Swap*

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