Bankers Trust and Procter & Gamble, 1994

At a glance

What happened

In late 1993 Procter & Gamble's treasury wanted cheaper floating-rate funding. Bankers Trust offered a swap that paid P&G a fixed rate and let it pay commercial paper rates minus 75 basis points, plus a spread to be set in 1994 by a formula tied to five- and thirty-year Treasury yields. If rates stayed put, that spread would be zero. The Federal Reserve began raising rates in February 1994, and by the time P&G fixed its spread in March it was about 14 percentage points a year for the rest of the deal.

Why it went wrong

The formula made the spread extremely sensitive to rising rates: a one-point rise in yields moved it by roughly 29 points. In effect P&G had sold the bank a leveraged option on higher rates, and the 75 basis point saving was the premium. P&G could not value the structure itself and depended on the dealer's prices, including when deciding when to lock the spread. It was a one-way bet on calm rates, placed at the end of a long rally.

What it teaches

If you cannot value a trade yourself, you cannot know what you are paying for it. A funding cost that looks too good to be true is usually the premium on an option you have written. The case, along with Gibson Greetings and Orange County, pushed the industry towards clearer standards for selling derivatives to corporate clients.

Key terms

Leveraged swap

A swap whose payments move by a multiple of the change in a market rate, rather than one-for-one.

Commercial paper rate

The short-term rate a large company pays to borrow unsecured in the money market.

Embedded option

An option built into another instrument’s terms, often visible only as an unusually attractive price.

Rate lock

Fixing a formula-driven spread at a given date, after which it no longer moves with the market.

Independent valuation

A price for a position obtained without relying on the dealer that sold it.

Suitability

Whether a product fits a client’s understanding, objectives and capacity to bear its risk.

Where it sits in the course

Case studies like this one are used throughout risk management teaching, including FRM® preparation, as worked examples of model and valuation risk; mis-selling. In OTC Learn the lesson runs in five steps: what happened, the position, why it broke, what it cost and what it teaches, followed by a worked example with the numbers. See the lesson outline.

Related case studies

• Orange County, 1994A conservative bond portfolio, borrowed three times over

The instruments behind it

OTC Learn lessons on the products this case turns on:

• Interest Rate SwapTrade fixed for floating payments
• SwaptionAn option on an interest rate swap