Derivatives of Proctor and Gamble in 1994 - Essay Example

In 1993, P & G swapped borrowed money using two contracts that floated the U. S dollar and the Deutsche Mark currencies. The aim was that with the American currency falling further, P &G would make handsome returns in addition to paying the debts. The deal was going on well with the company making small losses and gains to balance the losses, an indication that all systems were right. However, in mid-April 1994, Artzt, the chairman of P & G, made a shocking revelation that the company had made a whopping $157 million loss after liquidating two interest rate swap contracts (Smith, 68).

This was in addition to a $102 million after-tax charge against the company’s third-quarter profits to cover the losses incurred in the transaction (Malkin, 1994). The scenario was that P $ G had signed a contract that considerably magnified the interest rate swings in a 3 years swap in which the company paid a floating rate on Libor (Smith, 69). The intention of the company was to make an interest in the event that interest rates fell or remained constant, which could have led the prices of the relevant bonds to increase or remain constant.

As a result, the company could have paid the expected Libor rate while still benefiting from the income from Bankers Trust for the options. However, the short-interest rates rose significantly leading to a decline in the prices of the long-term bonds, forcing P & G to buy the derivatives at rates way above the selling value. In other words, P &G found itself paying rates above the selling value due to the sensitivity of the long-term bonds to the slightest movement in interest rates. Consequently, P & G had to pay much higher to purchase back the derivatives from Bankers Trust than what the bank had paid for them due to the increase in the value of the options held by the bank as a result of a rise in interest rates (Heffernan, 641).

P & G incurred the above losses due to interest rate volatility in the market, which made the company buy its swiped instruments at much higher costs than the bank had paid. The outcome of the transaction was that two P & G employees considered to bear the greatest responsibility in the derivatives were reassigned and the company’s treasurer, Raymond Mains, chose to proceed for early retirement (Malkin, 1994). Moreover, there was a fierce court battle between the company and the trust bank that sucked in government agencies to investigate the case.

Luckily, the deal did not affect the company’s operations as the final settlement declared that P& G was entitled to pay Bankers Trust $35 million and not $ 135 million as claimed (Heffernan, 641). The major lesson in the deal was that derivatives are risky instruments to deal with due to too unforeseen risks. For instance, the P& G and Bankers Trust contract were too complex that the risks entailed in the contract, and their implications evaded the comprehension of P & G financial advisers (Malkin, 1994).

Moreover, the implications of this deal were that managers of any firm involved in derivatives have an active role to critically examine the market and understand the possible risks and rewards involved before deciding to invest in the contracts. In other words, if a company does not understand the rewards and the risks involved, they should keep off derivatives, but should not be cheated by short-term gains without considering the potential risks.