Bankers Trust and Procter & Gamble, 1994

A cheaper loan that was really a sold option

In November 1993 Procter & Gamble entered a five-year interest rate swap with Bankers Trust on $200m notional. P&G received a fixed 5.30% and paid commercial paper rates minus 75 basis points — below its normal funding cost — plus a spread to be set in 1994 by a formula linked to five- and thirty-year Treasury yields. If rates stayed where they were, the spread was zero. The Federal Reserve began raising rates in February 1994, and the formula’s leverage turned a rise of around one percentage point into a spread of about fourteen. P&G took a charge of $157m on this and a second leveraged swap, sued, and settled in 1996.

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What the lesson covers

1. What happened
2. The position
3. Why it broke
4. What it cost
5. What it teaches

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.

Every key term, A to Z

In practice

Corporate treasuries now hold a rule that this case wrote: no derivative without an independent valuation and a stated hedging purpose, and any structure offering below-market funding is broken down into its components before it is signed, so the option inside it is priced on its own.

Read next

• Interest Rate Swap — Trade fixed for floating payments
• Swaption — An option on an interest rate swap
• Orange County, 1994 — A conservative bond portfolio, borrowed three times over

In the app, Bankers Trust and Procter & Gamble, 1994 carries a five-step lesson, a worked example and a bank of twelve questions drawn differently every sitting.

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