Introduction: On 2nd November, 1993, Procter & Gamble (P&G) entered into a five year

swap contract with Bankers Trust (BT) with semiannual payments and a notional principal of

$200 million, which turned out to be a bizarre deal and infamously known as the “5/30”

swap.

Strategies and the Transactions involved: BT paid fixed rate of 5.30% and P&G paid a

floating rate that was based on the average 30-day commercial paper rate minus 75 basis

points plus a spread. Spread is the payoff to BT in the form of a higher margin over the CP

average floating rate.

5.30% Five-Year, Semiannual Settlement Interest Rate Swap

BT P&G
30-Day CP Daily Average -75 Basis Point + Spread

Spread was calculated using the following formula:

5 − 𝑦𝑒𝑎𝑟 𝐶𝑀𝑇%
98.5 ( ) − (30 𝑦𝑒𝑎𝑟 𝑇𝑆𝑌 𝑃𝑟𝑖𝑐𝑒)
5.78%
Max [0, ]
100

In this, CMT is the Constant Maturity Treasury Yield (i.e. yield on a 5 year treasury note).

The 30-year TSY price is the midpoint of the bid and offer cash bond prices for the 6.25%

Treasury bond maturing on August 2023.

If the 5-year treasury yield was high and thirty-year treasury price was low, the payoff would

have increased, which is why it was named “5/30 swap”. The formula shows that even the

smallest increase or decrease in interest rates should result in an incrementally larger change

in P&G's position in the swap.

P&G was expecting the spread to be zero and hedging against decreasing interest rate by

exchanging fixed rate funding at 5.30% for funding at 75 basis points less than the

commercial paper rate.

What went wrong?

The contract was negotiated in 1994 and then interest rates increased significantly, the bond

prices fell, the spread increased and the floating rate paid by P&G went extremely high and

as a result the swap proved to be very expensive for P&G. P&G had to accumulate a huge

loss of $157 million. P&G then filed a lawsuit against BT seeking declaratory relief and

damages with respect to interest rate swap transactions. The chief financial officer claimed

that they were unaware of the intricacies of the contract, as BT had not stated clearly the risk

inherent in the contract and that P&G had given the funds in good faith. They had no real

reasons to go into the details of the contract, as the returns were good. P&G claimed that by

the time it completely understood the mechanism of financial derivatives they were asked to fork

out $40 million as extra financing costs. They later came to know that BT had been using a

proprietary model to calculate these costs. So, the costs and payouts were not fully clear either.

BT on the other hand countered that P&G also had its panel of experts to do the interest rates

forecasts prior to engaging into the deal. BT also contended that P&G should have been

more informed about the mechanism of complex derivatives before channeling funds into the

derivative deal and also that they had no complaints regarding the deal when interest rates

were low and they were making handsome gains.

During the trial P&G found out a number of taped conversations among the employees of

BT, in which they were discussing about how much money they pulled out from P&G and

other such clients with whom they entered into various deals and how these parties will never

find out to how much risk these parties were exposed to. So, the case was going more in

favor of P&G than it was expected, and then finally BT went for an out of court settlement

for a net of $78 million with P&G. BT also had to settle for $93 million with Gibson

Greetings, Air products and Chemicals and Federal Paper Board Company various other

companies which had to bear losses on many such deals with BT.
 Who was responsible for this bizarre outcome?

By going through the entire scenario it is pretty obvious to blame Bankers Trust for this

debacle that occurred in 1994 as it was unethical and dishonest in their part for not providing

detailed information to P&G (and other clients as well) on how the derivative worked and

how it could have detrimental effects on the gains with an upward movement in the interest

rates. BT was the one that initiated the contract and had more expertise than P&G in financial

engineering, and they designed the formulas to determine spread and floating rate in such a

complex way that was very difficult for the other party to understand that things could go

tremendously wrong.

BT probably wanted to make profits at any cost even if it meant by deceiving its clients,

which eventually shattered their reputation overnight.

However, having said it was still very irresponsible and foolish on P&G’s end to blindly trust

a financial institution like BT and channel such a huge amount of fund without having a clear

understanding on the technicality of the deal. They should have gone for an in-depth

investigation.

Lessons learnt from this disaster:

 It is extremely important for every investor to have a clear knowledge about derivatives, how

it will work and the amount of risks inherent before engaging into such deals and assigning

their funds into it.

 There should be more strict regulations on Derivatives transactions. Although most swap

deals occur over the counter and little regulation is possible, in that case parties involved in

the deals should have in-details, strict contract terms and conditions which will not allow any

party to play fraudulently or deceive the other party.