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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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