Exotic Caps- Proctor & Gamble Swap (1993)
May 18, 2006
Team Latte

In November 1993 Proctor & Gamble had a swap that was maturing and the company wanted to replace it with another swap. The existing swap was achieving CP- 40 b.p. and it was difficult to get this rate without taking on some additional risk. The gamble for the company was that the U.S. interest rates would remain stable for the next half a year and the Finance Department of the Company was willing to take this gamble.

Enter Bankers Trust (BT), the leading quantitative investment bank of the day, and the result was a following swap transaction:

•Notional Principal:	$200 million
•P & G to receive:	5.30%
•P & to pay for first 6 months:	daily average 30-day CP- 75 b.p.
•P & G to pay for the remaining 4.5 years:	daily average 30-day CP- 75 b.p. + P

Where the parameters were defined as the following:

•P & G had the option to buy back within the first six months at market value.

In essence P & G was selling an option, P to Bankers Trust. is an embedded exotic cap (a call on the interest rate) . The option is an exotic option because the spot and the strike of the cap is a function of not only the yield (rate) but also the bond price.

Bankers Trust's rationale in selling this transaction (the swap plus buying option from P & G) was that if the interest rates and the volatility remained stable for the 6 months following the inception of the swap then the buying back the option from BT would roughly cost P & G about 37 basis points for the rest of the five years and therefore would meet P & G's target of achieving the rates on the existing swap (CP- 40 b.p.).

The following crucial points should be noted about the embedded option:

1. S was not some kind of a "spread", as it may appear on first look, and as may have been perceived by the P & G Finance team. S is actually a combination of spot and strike (one can decompose the identity in the bracket to see the exact nature of the spot and the strike) which are both on the same side of the market, i.e. if the rates go up then would uniformly increase as the bond yield will increase and the bond price will decrease.
2. Secondly, there is a high leverage factor associated with which will amplify the losses (and profits) if there is one and the leverage factor iss not 17.04 which once again may be inferred from a cursory look at the payoff; in reality the leverage factor is much higher than this (the reader can work this out).

At the time the swap was transacted everything looked fine and P & G was happy to enter into the transaction. However, in the early 1994, shortly after the swap was transacted, the interest rates in the U.S. started to go and the bond markets reeled from falling prices and increasing yields. This caused P & G to lose a lot of money on the swap as its obligation to pay BT, which was tied to the exotic cap, increased exponentially. The rest is history.

Source: The above case study is taken from Swaps and Other Derivatives by Richard Flavell (John Wiley & Sons, 2002)

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