Reference no: EM133268869
CASE ANALYSIS - In October 1993, P&G contracted USD100 million through Bankers Trust of their fixed-rate debt for a floating interest rate in a deal called a fixed- for-floating swap. P&G was of the view that the interest rate would fall and accordingly was not accepting the proposal by Bankers Trust even to hedge the risk associated with the contract. If the interest rate did not turn the way the firm expected, P&G would face additional risk.
Due to confidence in the future direction of the interest rate environment, in November 1993 P&G signed an additional USD200 million five-year swap. The condition of the first six Months was not to pay a floating rate of 40 basis points below of commercial paper rate like the first contract, but 75 basis points. For the remaining 4.5 years, the floating rate was to be dictated by a formula whose components would have included a 5-year and 30-year treasury rate as of 4 May 1994. In the best situation for P&G, the floating rate would continue at 75 basis points and, in the worst rate, P&G would incur a loss of millions of dollars.
It was expected that P&G could gain up to the maximum and save a 75 basis points for five years, amounting to USD 1.5 million a year and, in five years, USD 7.5 million. But in early November, the 5-year treasury rates roses from 5% in November to 6.7% on 4 May 1994 and P&G other benchmark went up from about 6% to 7.3%.
Despite the rising rate, P&G entered a second highly leveraged swap with Bankers Trust for USD93 million for a 4.75-year period, all with the perception that the rate would continue to decline. In the first year, things turned good and offered a promise of a USD940,000 total saving in five years.
However, the formula stated for the 4.5 years had two potentials weaknesses: (1) if the rate jumped out of the prescribed band; and (2) if the swap rate was above the 4.5% benchmark rate on 14 April 1995, P&G would be paying interest that included its base rate for the first year plus spread. The spread given by Bankers Trust was 10 times the difference between 4.5% and the swap rate.
In early March the swap rate flew out of the band on the upside rate. P&G knew that worse was coming and it tried to mitigate the danger by negotiating a lock-in interest rate for each of its swaps. But it faced problems due to the "secret and proprietary etc." pricing model of the bank that itself hedged after making the first swap contract. It managed finally, to lock in rates on both swaps and confronted the horror of the ensuing financial loss. In the end P&G went on to lose USD157 million due to the hike in the Interest.
Case questions -
1. Outline the structure of the swaps which P&G had with Bankers Trust.
2. The swaps P&G entered into with Bankers Trust was on the assumption that the interest rate would remain stable or fall. How do you view the transactions, both the first and the second swap.
3. P&G had a series of similarly complex swap transactions with Bankers Trust previously. Analyze their attitude and policy.