PROCTER & GAMBLE
DERIVATIVES LOSS
(1994)
Risk Analysis and Mitigation Strategies
GROUP 5
JACK BYRNE- 48432,
JIJO MATHEW -48471,
SNEHA AJIMON -48037,
SOWJANYA ANAND -10782,
MRUDHULA VIJAYAKRISHNAN -14817.
Contents
1. Introduction………………………………………….2
2. Risk Identification ………………………………….2
3. Quantitative analysis summary………………….4
4. Risk Mitigation Proposal………………………….8
5. Conclusion…………………………………………12
6. References…………………………………………12
7. Executive Summary………………………………13
8. Appendix….………………………………………..14
Page 1 of 14
1. Introduction
In 1994, Procter & Gamble (P&G) sustained significant financial losses in
complex interest rate derivatives resulting in a $157 million litigation dispute.
The case stands as an admonitory case against the mismanagement of derivatives,
especially if companies get into complex financial instruments without fully
understanding their possible exposures. P&G entered into complicated interest
rate swaps with Bankers Trust, hoping to take advantage of favourable interest
rates. On the other hand, earlier changes in the market, improper risk assessment,
and inappropriate market valuation resulted in the wreckage of tremendous
proportions. The entire event showcases the need for risk management practices
and their effective disclosures to the corporate finance world.
2. Risk Identification
Primary Risk Types
In 1994, Procter & Gamble (P&G) incurred a derivatives loss primarily caused
by market and model risks, elaborated on below. These risks arose from the
company's exposure to interest rate fluctuations and dependence upon complex
financial instruments that had not been credibly assessed. P&G also incurred
counterparty risk, as it depended heavily upon Bankers Trust for valuation and
risk management, creating potential conflicts of interest. The absence of
independent risk assessment and transparent regulatory regulation aggravated the
problem, leading to huge financial losses in the end.
Market risk: Interest rate fluctuations played a very significant role in the losses
that P&G incurred. The derivatives contract it embarked on were very sensitive
to changes in interest rates, and the company lacked a sufficient hedge even for
the worst-case scenarios. Thus, any unexpected movement in rates multiplied the
amount of loss financially caused by the embedded leverage in these instruments
through embedment.
Model Risk: P&G depended on the valuation models of Bankers Trust without
performing an independent risk assessment. The financial models that were
founded did not sufficiently reflect the extent of complexities of the structured
Page 2 of 14
derivatives; at best they gave mispriced risks and unexpected exposure levels.
This brings up a further aspect of risk that comes to light in the overall
dependence on external risk assessments without internal validation.
Counterparty Risk: Bankers Trust - who structured and sold the derivatives had a clear information advantage over P&G. Bankers Trust, according to later
internal memos, intentionally structured the derivatives with hidden risks and
took advantage of P&G's limited expertise in complex financial instruments. All
of this increased the extent to which P&G was vulnerable.
Regulatory risk - P&G suffered from regulatory risk in the sense that, because
of loopholes in the financial disclosure rules, most risky derivative deals went
unnoticed. Such loose supervision implied a lack of transparency in the abovementioned complex financial instruments, thus not giving an accurate picture of
the real level of exposure. The absence of clear regulations on structured
derivative instruments meant that P&G had unknowingly assumed higher risks
than it had anticipated, with severe financial and reputational consequences.
The speculative risks: These other efforts, taken not just for the purpose of
hedging, expose P&G to further financial risk. The company took some positions
in derivatives not merely for mad-effective risk mitigation, but rather with a view
to enhance any potential gains in doing so while subsequently increasing the risk
from its exposure to adverse market scenarios. When markets turned against
them, such speculative incidents often resulted in huge losses, fully showing the
dangers associated with beyond-risk management usage of financial instruments.
Cause
There were several specific reasons why P&G lost money in this case. The
structured interest rate swaps were complex instruments that featured embedded
leverage and nonlinear payoffs, the potential downside of which lay beyond the
full comprehension of P&G's internal risk management team. Furthermore, the
absence of internal capabilities to evaluate such instruments led to over-reliance
on Bankers Trust for risk assessment. However, this over-reliance blurred the line
of independence from a conflict of interest perspective, as Bankers Trust had
direct incentives to market these derivatives. Besides, P&G did not perform its
independent valuation but instead relied on Bankers Trust's models, which might
not have accurately captured the true risk exposure. The issue of regulatory gaps
in the control of derivatives in the 1990s worsened the situation by permitting
Page 3 of 14
limited disclosure requirements, whereby shareholders and auditors were not
fully aware of the extent to which P&G was exposed to derivative risks. Lastly,
P&G traded these derivatives not just for hedging but for speculative profit from
its expectation regarding movement in interest rates. This speculative approach
translated into financial volatility and, eventually, millions in losses.
Contributing Factors
These losses from derivatives were also caused by several major factors. The
most significant was the enormous complexity in the interest rate swaps that P&G
entered which contained embedded leverage and nonlinear payoffs. It made the
company subject to a lot of market fluctuation. The risk management team at
P&G did not have the complete skills to understand these instruments and, as a
result, underestimated possible exposure. In addition, they depended a lot on
Bankers Trust's models in valuation, without conducting independent assessment,
which further increased their vulnerability to mispricing and hidden lurking risks
in the derivatives market. This was further compounded by regulatory loopholes
and scantiness of transparency in the derivative markets because financial
disclosures by P&G were just not commensurate with the full extent of their
exposure. These derivatives, too, being leveraged, would create huge detriments
with minor movements in interest rates. P&G rather went into derivatives not so
much for hedging purposes but as though it were speculating.
3. Quantitative analysis summary
This section provides a quantitative exploration of the financial conditions and
risk exposures underlying Procter & Gamble’s derivatives loss in 1994. The aim
was to explore the intersection of interest rate changes and market risk for P&G,
while simply affected by the firm's leveraged interest rate swap positions.
Interest Rate Environment (1993–1994)
The analysis started with an overview of the short-term interest rate landscape. In
early 1994, the Federal Reserve embarked on a tightening cycle, raising the
Federal Funds Rate from about 3% to more than 5.5% in the course of that year.
This shift in policy was mirrored in 3-month T-Bill rate used as the LIBOR proxy
as it had much more consistent historical availability (Quarterly Vs Daily).
Page 4 of 14
The regime change is clearly illustrated in a comparative time series of the
Federal Funds Rate and T-Bill rates. P&G swap exposure represented by the loss
chart below, models our best estimation of loss on derivatives for P&G as the
terms of the OTC swaps were not public.
P&G Share Price Response
P&G’s stock price had been on a slow dive since early 1994, before the
derivatives loss became publicly known in April of that year. This could mean
that markets started to take into consideration potential distress events or reacting
to internal performance signals that were likely hinted at or reported on elsewhere
before the fact.
Page 5 of 14
The stock price did recover a bit after the announcement, which may indicate
some level of relief or at least, investor confidence in the company and its place
in the market. To better understand the timing of this relationship, a lagged
correlation analysis was performed between the changes in the T-Bill rates and
P&G stock returns. The results showed that when accounting for the interest rate
shocks in the short-run, its effect on the long-run equity performance is easily
seen.
VaR and ES Analysis
Market risk exposure via Value-at-Risk (VaR) and Expected Shortfall (ES) were
calculated using four different methods:
Page 6 of 14
Parametric
VaR
Historical
VaR
EWMA VaR ES
95%
–2.08%
–2.08%
–1.73%
–2.44%
99%
–2.63%
–2.63%
–2.41%
–2.94%
While the consistency between the parametric and historical-based daily return
VaR would make the assumption that there is not much daily return volatility,
the parametric model may still overstate tail risk due to the application of the
normal distribution assumption as we can see above there is a much fatter left tail.
Expected Shortfall gives us a broader measure of downside risk, considering the
average loss that occurs on the tail of the distribution after the Value at Risk level.
VaR Backtesting
Also a simple backtest of the 95% historical VaR model was performed by
comparing the number of breaches of actual returns against the expected under
the assumptions of the model. Results showed very close alignment with the
theoretical proportion of violations: Actual 95% VaR violations: 27 | Expected
95% VaR violations: 26 | Violation rate: 5.14%
Page 7 of 14
4. Risk Mitigation Proposal
Shortcomings in P&G’s Risk Management Practices
P&G’s primary failure was its lack of expertise in complex derivatives. The
company played the game of leveraged interest rate swaps without a proper
understanding of the risk factors. The historical VaR and ES analysis of P&G’s
stock returns shows periods of extreme losses, indicating significant downside
risk. However, P&G focused on short-term cost savings instead of assessing the
possibility of sharp market fluctuations. Proper stress-testing using historical loss
data could have revealed the potential for financial distress, yet the company
failed to connect derivative risk with market volatility. Another key problem was
the over-dependence that P&G had developed on its external counterparty,
particularly Bankers Trust. The company relied on their risk assessments rather
than its own evaluation. The steep left tail of P&G's return histogram suggested
that major losses were possible, which were risks either undisclosed or
misunderstood. Without an independent verification of its assumptions, P&G was
left exposed to financial shocks.
P&G also lacked stress-testing and scenario analysis. The company assumed a
constant interest rate, ignoring sharp raises in interest rates. The extreme loss
events recorded between -2.5% to -3% daily declines in the return distribution
graph show the need for better scenario planning. Instead of stress-testing their
positions using any reasonable amount of historical market data, P&G allowed
wishful thinking to drive their assumptions. The company ultimately posted a
$157 million loss due to an unexpected spike in rates, which ultimately could
have been avoided or at least mitigated through the use of more realistic
simulations.
Lastly, P&G had weak internal risk governance. The company lacked sufficient
controls to monitor the risks of complex financial instruments. The probability
density of negative returns in the histogram suggests foreseeable losses, yet risk
governance failed to align with this reality. Stronger governance could have
provided more oversight to the risk assessments, which would have likely
identified uncontrolled exposure before compensatory damage occurred.
These failures illustrate that P&G underestimated tail risk, depended too much on
external parties, did not conduct proper stress testing, and lacked strong oversight.
These would have otherwise been integrated with an analysis of historical VaR
Page 8 of 14
and ES in order to identify and mitigate these risks before they would cause
massive financial losses.
Evaluation of P&G’s Response to the Risk Event
In response to the $157 million loss due to risk, P&G decided to take legal action
against Bankers Trust alleging the misrepresentation of risks with the interest rate
swaps and failure to show transparency on possible losses. Although this lawsuit
led to financial settlements and exposure of misleading banking practices, the
approach of P&G was quite reactive instead of proactive. Instead of addressing
the internal weaknesses immediately, the company put more weight on external
accountability, missing an opportunity to better strengthen its own risk
management framework.
Positive Aspects of the P&G Response
P&G has largely been helped in its financial recovery through the settlement of
legal action. It would enable the corporation to recover part of its losses suffered
from Bankers Trust. More importantly, it uncovered duplicitous banking
practices in Bankers Trust with respect to the need for increased transparency in
derivative transactions. It set a landmark ruling on corporate accountability-as
just accountability for financial institutions that mislead their clients with respect
to the dangers involved in complicated financial products. Another significant
outcome is more regulation over derivatives trading. The case attracted a lot of
public and regulatory interest into discussions as to the need for tougher financial
disclosure requirements. This further increased the tightening of rules in the
derivatives market and significantly minimized the chances of such
misrepresentations occurring in the future. P&G, by throwing light on those
issues, indirectly brought about improvements in the practice of the financial
industry.
Weaknesses in P&G’s Response
Despite taking legal action, P&G did not immediately implement substantial
internal reforms to improve its risk management framework. Instead of focusing
on strengthening internal controls, the company concentrated on external blame.
Thus, it failed to act quickly on governance weaknesses and as a result, P&G is
open to the contingency of financial missteps in the future.
Page 9 of 14
Further, risky derivative trading involved a lot of reputational damage to P&G. It
highlighted to investors and analysts that a consumer goods company had been
seen losing money as a result of lawsuits related to derivative trading of
complicated financial instruments without the required knowledge or oversight.
This thus raised a few eyebrows among investors and analysts, spelling out
damage on P&G regarding financial discipline and governance structure.
Finally, it did not touch the concerns of internal risk governance weaknesses.
Although the lawsuit took the bank to court over its contribution to the losses,
changes could not be seen at P&G in key aspects of its risk assessment, stress
testing, or independent oversight. Without proactive reforms in risk management,
the risk is that such financial risks will not be mitigated by the organization in the
future.
Recommended Risk Mitigation Strategy for Procter & Gamble
Transparent and Standardized Instruments
P&G’s use of overleveraged interest rate swaps made the company susceptible to
unforeseen risks. Instead, it would have been wise for the company to go about
hedging using transparent and standardized instruments such as plain vanilla
interest rate swaps and interest rate caps or floors. This allows for transparency
in pricing, decreased counterparty risk, and better valuation, preventing varied
perceptions of risk.
Strengthening Risk Governance
To guard against any future occurrence of risk, a specialized risk management
authority should exist independently from the treasury and trading departments
to give an unbiased check on transactions. Definitely, the practice of board
oversight in at least approving any high-risk transaction as an accountable
measure should come into play, while also being able to set pre-approval
procedures with limits to exposure in cases of derivatives, thus staving off the
risk of speculative trading. A structured risk governance framework would have
prevented an over-reliance on a single counterparty (Bankers Trust) and increased
internal accountability.
Pre-Trade Risk Assessment and Modelling
Page 10 of 14
At pre-trade, Risk assessments aided by value-at-risk modeling should have been
used to envisage potential losses by way of scenario analysis and stress testing
under extreme market conditions and sensitivity analysis to appreciate the value
changes of derivative contracts when interest rates change. This would have
provided a quantification of conservative scenario and tail risk, which would be
readily measurable by P&G together with the value of complex derivatives in
order to ward off any hidden exposures.
Hedging Strategy Alignment
To encounter future vulnerabilities, the company should establish a formal
hedging strategy that accounts for swaps and other risk management tools to
create a balanced risk-return profile. A streamlined approach will ensure
derivatives are used solely for risk control, protecting financial performance from
speculative volatility. Opting for STIR as a hedging instrument would have been
a better option as it would have had the flexibility of giving up the position when
the loss incurred. Same was not possible in this case as it was OTC and they could
not exit the position.
Independent Valuation and Counterparty Oversight
Due to the reliance on Bankers Trust as the source for pricing and structuring the
derivatives, there was, in effect, a conflict of interest. In order to avert any such
possibility of misrepresentation, there should have been independent pricing
models of their own or use of a third-party valuation service to confirm the
derivative values.
Page 11 of 14
5. Conclusion
To avert recurrences of future financial mishaps, risk management should be
implemented at P&G in a disciplined and structured manner. This will also
include duly implementing transparency, independent valuation, hedging strictly
on derivatives prohibited from speculation, stronger management training, added
pre-trade risk assessment, and aligning financial strategy with actual business
needs so that the risk exposure is limited. In addition, nurturing risk awareness at
the organizational culture level will ensure that the company is protected from
similar events in the future.
6. References
Federal Reserve Bank of St. Louis (2025). FRED Economic Data. [online]
Stlouisfed.org. Available at: https://fred.stlouisfed.org/.
Yahoo Finance (2024). Procter & Gamble Company (The) (PG) Stock Price,
Quote,
History
&
News.
[online]
@YahooFinance.
Available
at:
https://finance.yahoo.com/quote/PG/.
New York Times (1996) ‘Bankers Trust settles suit with P&G’, The New York
Times,
10
May.
Available
at:
https://www.nytimes.com/1996/05/10/business/bankers-trust-settles-suit-with-pg.html (Accessed: 22 March 2025).
Investopedia. (n.d.). Short-Term Interest Rate (STIR): Definition, Uses, and
Examples.
Retrieved
March
27,
2025,
from
https://www.investopedia.com/terms/s/stir.asp
Fabozzi, F. J. (2003). Short-term interest rate models. In F. J. Fabozzi (Ed.),
Handbook of Fixed Income Securities (pp. 407-427). Academic Press. Retrieved
from
https://www.sciencedirect.com/science/article/abs/pii/B9780120884384500150
Page 12 of 14
7. Executive Summary
In 1994, Procter and Gamble (P&G) suffered financial loss due to its participation
in complex interest rate derivatives that resulted in a $157 million litigation
dispute. The primary reasons contributing to this loss is due to Market risk, Model
risk, and counterparty risk. The losses were amplified by various key factors, such
as the complexity of structured swaps, inadequate internal risk management
controls, and the dependency on Bankers Trust, and P&G’s speculative approach
instead of having a strict hedging strategy. The federal reserve’s interest rate hikes
and the market downturn has infected financial distress and thus leads to erosion
of shareholder’s value. P&G responded to the crisis by taking legal action against
Bankers Trust, alleging misrepresentation of risks. This lawsuit came to an end
by a financial settlement, and it also exposed the unethical banking practices. To
mitigate the future financial risks, P&G should adopt a comprehensive financial
risk management strategy that consists of transparent and use of standardised
financial instruments, independent mechanisms for valuation, and rigorous pretrade risk assessments and a well-defined hedging strategy.
By implementing this, P&G can enhance its financial resilience and improve the
confidence of its investors and ensure a more structured approach to risk
management, Preventing similar financial mishaps in future.
Team contributions
Sowjanya Anand has spent time in gathering and collecting data to Identify
different types of risk and its contributing factors.
Jack Byrne handled all the quantitative analysis contained within this report
contained within the IPYNB file and also is responsible for writing up and
reporting on those findings in section 3.
Sneha Ajimon was responsible for gathering and collecting information on
collecting information and presenting information on Risk Mitigation proposal
Mrudhula Vijayakrishnan was responsible for gathering and collecting
information and recommended risk mitigation strategies for Procter & Gamble.
Jijo Mathew spend his time on working on the presentation format while also
contributing toward gathering data which helped convey essential report insights.
Page 13 of 14
8. Appendix
FRMGroupProject.ipynb
Page 14 of 14