Page 10 - DCOM510_FINANCIAL_DERIVATIVES

Unit 1: Introduction to Derivatives

1.2.2 Interest Rate Derivatives Notes

One of the most popular interest rate derivatives is interest rate swap. In one form, it involves
a bank agreeing to make payments to a counterparty based on a floating rate in exchange for
receiving fixed interest rate payments. It provides an extremely useful tool for banks to manage
interest rate risk. Given that banks’ floating rate loans are usually tied closely to the market
interest rates while their interest payments to depositors are adjusted less frequently, a decline
in market interest rates would reduce their interest income but not their interest payments on
deposits. By entering an interest rate swap contract and receiving fixed rate receipts from
counterparty, banks would be less exposed to the interest rate risk. Meanwhile, interest rate
futures contract allows a buyer to lock in a future investment rate.

Example: The Chicago Board of Trade offers federal funds futures contracts ranging
from the current month to 24 months out. A by-product of these futures is that they provide
useful information on the market expectations of future monetary policy decisions in the United
States (Carlson, Craig, Higgins and Melick (2006)).

Caselet Procter & Gamble entered into Interest Rate Swap

rocter & Gamble Co. is a Fortune 500, American global corporation based in
Cincinnati, Ohio, that manufactures a wide range of consumer goods. In late 1993,
PProcter & Gamble financial managers, well known for actively managing their
interest costs, expected interest rates to drop and went to Bankers Trust searching for
aggressive interest rate swaps that would allow them to profit on these expectations. P&G
told to Bankers Trust about ways of replacing a fixed-to-floating swap that was maturing.
P&G’s specific objective was to negotiate a new $100 million swap that would (a) again put
it in the position of paying floating rates and (b) squeeze these to a minimum. Specifically,
the company wanted to pay 40 basis points (0.4 of 1%) less than its standard, upper-crust
commercial paper rate (then about 3.25% for six-month paper). Bankers Trust responded
with a highly levered, extremely risky, and extremely complex five-year interest-rate
swap agreement. In this the P&G had to pay 75 basis points less than rate of Commercial
Paper, if the interest rates of 30 years and 5 years treasury bills will remain constant or go
down. Five-year Treasury rates rose from 5% in early November 1993 to 6.7% on May 4,
1994. P&G’s other benchmark, 30-year Treasury rates, went from about 6% to 7.3%. Because
of large duration the effect of rise in interest rate on long term bonds was very high. When
interest rates headed up, Procter & Gamble’s treasurer realized the magnitude of the
company’s potential derivatives losses and decided to get out of the swap. Because of the
intricate complexities and linked derivatives of the agreement, however, P&G lost $157
million to lock-in interest rates (which were 1,412 basis points (14.12%) above the
commercial paper rate) in only six months of a five year contract. When interest rates
headed up, Bankers’ trust entered into another contract with P& G - a wedding band. When
this strategy also failed, it led P& G to pay even higher rate of interest from 14.12% above
Commercial Paper (CP) to 16.40% above CP. CEO Edwin Artzt, called the swaps “a violation
of the company’s policy against speculative financial transactions” and banned all
leveraged swaps. As the Bankers Trust had suggested the contracts, P& G blamed them for
the losses.

Source: http://www.iitk.ac.in/infocell/announce/convention/papers/Colloquium-03-Swati%20
Khatkale%20final.pdf

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