Proctor Gambles And Loses

FINC 456

Motives For Studying P&G Swap

P&G swap clearly demonstrates the critical interaction between financing structures and market events. Excellent case study for risk identification and deengineering. The basic structure of the deal is extremely common, and represents the goals and interests of many corporate clients

Classic tradeoff of paying for something by not understanding risks

Lessons from P&G Swap

There is no free lunch in derivative products!

Below-market financing results from the risk of potential loss Money is paid for taking risks; not given for free

Methodology for decomposing complex financing structures and risk identification

Finding the underlying assets Understanding the payoffs under different scenarios Quantifying the payoffs in a meaningful and intuitive manner

Corporate motivations, selling points, and appropriateness issues

Where is the line between speculating and hedging?

The P&G Swap

Near the end of 1993, P&G entered into a 5 year structured swap deal with Bankers Trust

P&G had commercial paper receivables, and wished to swap into a fixed rate.

P&G would pay a floating CP index and receive a fixed rate What does this imply about P&Gs interest rate view?
30 Day CP Average 75bp + Spread

The swap notional amount was $200MM. Proctor & Gamble

5.30%

Bankers Trust

The P&G Swap: The Spread

The fair market (fixed) swap rate for a CP swap was 5.30%. P&G was allowed to pay CP minus 75 b.p. in return for agreeing to add a spread to the floating rate. The spread, which could never be negative, was linked to the value of U.S. Treasury rates in 6 months. Questions

Can we decompose this deal into simpler products? What is the cost of each product?

The Spread: From complexity to simplicity

The spread to be added was to be computed according to the following messy formula:
5 yr UST yield 98.5 30 yr UST price 5.78% Spread = max 0, 100

Yikes! What to do about this? Dont panicthis sort of product can be analyzed straightforwardly and methodically.

The swap is the simple part of the dealset it aside. P&G has sold an optionbut when will it pay off and how much risk does it incur?

The Spread: Simplifying

First, what are the underlying assets in this deal?

UST 5 year and 30 year bonds Will the expected variability of rates matter for the value of the swap? Or, more simply, what happens to the spread if both yields increase? What happens if both yields decrease? What happens if one yield increases and the other decreases?

Second, understand the directionality of the deal:

What is the best outcome for P&G?

The Spread: Critical Questions

Is this option in or out of the money? Where are the breakeven points for this option? What would happen if the yield curve shifts up 100 bp? Down 100 b.p.? A natural approach to solving the problem of quantifying the risks in this option would be to figure out a range of possible outcomes for each underlying, and compute the spread for each...

The Spread: Sensitivities

Roughly, the spreads could be:

Potential Spreads
30 Year Yield
(prices) 119.1041 114.8618 110.8421 107.0316 103.4176 99.98822 96.73248 93.64002 90.70118 5.00% 4.50% 4.75% 5.00% 5.25% 5.50% 5.75% 0.187% 4.447% 5.25% 0.169% 4.429% 8.689% 5.50% 4.188% 8.449% 12.709% 5.75% 3.738% 7.999% 12.259% 16.519% 6.00% 3.092% 7.352% 11.613% 15.873% 20.133% 6.25% 2.261% 6.521% 10.782% 15.042% 19.302% 23.563% 6.50% 1.256% 5.517% 9.777% 14.037% 18.298% 22.558% 26.819% 6.75% 0.088% 4.349% 8.609% 12.869% 17.130% 21.390% 25.651% 29.911% 7.00% 3.027% 7.288% 11.548% 15.808% 20.069% 24.329% 28.589% 32.850% 87.9069 85.24872 7.25% 1.561% 5.821% 10.082% 14.342% 18.603% 22.863% 27.123% 31.384% 35.644% 7.50% 4.219% 8.480% 12.740% 17.000% 21.261% 25.521% 29.782% 34.042% 38.302%

5 Year Yield

6.00% 6.25% 6.50% 6.75% 7.00% 7.25%

Which are most likely?

P&G Swap: Does volatility matter?

How does volatility affect the value of the option?

What would happen if rates could only change a few b.p.? If rates were very likely to change, what does that imply about the value?

Variability affects the important question about what are the most likely scenarios. How would you determine where rates are likely to be in 6 months?

Forward rates Other options might have some information Are there events that could affect this in the intervening months?

P&G Swap: Volatility Continued

A very crude method to gauge the relative value of a transaction is to figure out what the chance of each outcome is and multiply the chance of that possibility by the gain or loss.

For the P&G deal, the price paid implied that there was a very small chance of the option finishing in-the-money. Be careful, the sum of all the chances cant be bigger than one! What are the most likely yield curve movements? What kinds of term structure shifts change the value of the deal the most?

An additional concern here is correlation:

P&G Swap: What do the numbers mean?

It is usually important to translate the numbers from percentages to actual cash values...
Potential Losses (Millions)
30 Year Yield
5.00% 4.50% 4.75% 5.00% 5.25% 5.50% 5.75% 6.00% 6.25% 6.50% 6.75% 7.00% 7.25% 1.59 37.91 5.25% 1.44 37.76 74.08 5.50% 35.70 72.02 108.34 5.75% 31.87 68.19 104.51 140.83 6.00% 26.36 62.68 99.00 135.32 171.64 6.25% 19.27 55.59 91.91 128.23 164.55 200.87 6.50% 10.71 47.03 83.35 119.67 155.99 192.31 228.63 6.75% 0.75 37.07 73.39 109.71 146.03 182.35 218.67 254.99 7.00% 25.81 62.13 98.45 134.76 171.08 207.40 243.72 280.04 7.25% 13.31 49.63 85.95 122.27 158.59 194.90 231.22 267.54 303.86 7.50% 35.97 72.29 108.61 144.93 181.25 217.57 253.88 290.20 326.52

Generalizing the De-engineering methodology

Identify the underlying assets Understand the directionality of the deal

Who wins when what happens?

Use the payoff to compute the sensitivity of the deal to various scenarios

Be sure to pick a very wide range of possible outcomes Which scenarios are most likely?

Quantify the risks in terms that are easily understood

The P&G Swap: The Big Picture

The P&G swap represents a classic structure for derivative linked financing

A corporation sells an option to receive either a more favorable swap rate or a lower cap premium

What was the premium that P&G received?

Other examples include interest rate collars, swaps with embedded floors, etc.

The basic rule is that costs are reduced by giving up profit potential

The flip side: profits are earned by incurring potential for loss.

What makes the P&G deal different?

The P&G Swap: Outcome

The terms of the deal are amended in January, 1994 to extend the maturity of the option part several weeks.

What else would have to have changed in the deal?

Butthe Fed raises rates at the February, 1994 meeting Yields rise by about 100 b.p. by the end of March, and P&G locks into a spread of 14.12%, for a total loss of $106MM P&G sues Bankers Trust for non-disclosure of risks and deceptive business practices

P&G Swap: Notes on appropriateness

Commercial banks have a responsibility to ensure that their clients understand the products that they buy.

Doesnt necessarily mean that clients must know how to price and hedge the products, just that they understand under which conditions payments might occur. How sophisticated is the client?

Are derivatives employed to manage other risks? How many corporate resources are devoted to the treasury?

A large grey area: when does taking a view and risk management become speculation?