BIG LOSSES BY NON-

FINANCIAL Pranamya Man

Dhoubadhel

INSTITUTIONS Priyanka Subedi

Rejika Joshi
Samyak Raj Shakya
Sparsh Jung Rana
Yukta Amatya
Procter & Gamble
  Founders: William Procter & James Gamble
 Industry : Beauty Groom & Household Care
 Location : Cincinnati, Ohio
 Supplied the Union Army with soap and candles
 They continued to purchase the company's
products
Introduction  Second half of the twentieth century, acquired
number of other companies
 P&G continued to grow and change
  P&G had derivative transactions with Bankers Trust
 In late 1993, P&G financial managers expected interest
rates to drop
 Went to Bankers Trust searching for aggressive interest
rate swaps
Summary  P&G's specific objective was to negotiate a $100 million
swap
 P&G told to Bankers Trust about ways of replacing a
fixed-to-floating swap that was maturing
 Specifically, the company wanted to pay 40 basis
points less than its standard commercial paper rate
 Bankers Trust responded with a highly levered,
extremely risky & complex five-year interest-rate swap
agreement
 In this the P&G had to pay 75 basis points less than rate
of Commercial Paper
 Five-year Treasury rates rose from 5% in early
November 1993 to 6.7% on May 4, 1994
 30-year Treasury rates, went from about 6% to 7.3%
When interest rates headed up, Proctor & Gamble's
treasurer realized the potential derivatives losses and
decided to get out of the swap
P&G lost $157 million in only six months of a five year
contract
When interest rates headed up, Bankers’ trust entered
into another contract with P&G
When this strategy also failed, it led P& G to pay even
higher rate of interest from 14.12% to 16.40% above
CP
As the Bankers Trust had suggested the contracts, P&
G blamed them for the losses.
  Positions taken by Procter & Gamble
 5 year interest rate swap
Analysis  Deutsche Mark swap
 Naked put options on government bonds
  5 year interest rate swap

Swap rates

Floating Rate
Bankers Trust
P&G

5.3%
Naked Put
Options
  Interest Rates Spiked
 Highly leveraged positions(leveraged swaps)
 Lack of expertise by managers in assessing market risk
Major Issues
 P&G managers did not understand the exotic
derivatives
  Importance of understanding the role of derivatives in
Lessons the market
learned  There is no free lunch
 Need for a strong supervision over financial derivatives
Metallgesellschaft
  Founded in 1883 A.D. by Wilhelm Ralph

 Based on Frankfurt with a turnover of $10 billion

 14th largest corporation in Germany with 58,000 employees and

251 subsidiaries
Introduction  Owned by major banks in Germany
  In 1991, hired Mr. Arthur Benson (expanded in derivatives)

 In 1992, company committed to sell at fixed price for 10 years

Summary  Initially company earned profit as price was stable and profit were
$5 per barrel

 But company kept a clause in its forward contract

 An option where buyer could terminate the contract

 If NYMEX provided better future position then, one half of

difference amount on volume remaining would be given

 In December 1993, a subsidiary reported a loss of $1.5 billion

  Metallgesellschaft initially offered fixed long term contracts to
deliver heating oil and gasoline to customers, wholesalers and
retailers
Event  Based on ‘BACKWARDATION’
overview  Contracts were ‘short position forward contract’

 Hedged against ‘long position futures contract’

 Hedged the exposure using stack-and-roll strategy

 The market moved in ‘CONTANGO’
 Profits were being earned from long position forwards

 Losses were compensated by short position futures

 WHAT CAUSED THE LOSS?

 MAJOR RISKS ASSOCIATED
1. Basis risk
Analysis 2. Liquidity risk
3. Operational risk
  Importance of hedge structures
 Stress testing
 Producers should not rely on their banks or trading counterparts
Learning to provide optimal hedging strategies.
 Understanding the hedge model
China Aviation Oil
  China Aviation Oil (Singapore) Corporation Ltd. (CAO)
was involved in the biggest scandal of the city-state of
Singapore since the Nick Leeson case (1995)

 Following losses of around $550 million, CAO filed for

bankruptcy in November 2004.

Introduction  Improper application of accounting principles, and

inadequate risk management systems for the
speculative options deal, were the major contributing
factors towards CAO’s failure.

 The CEO, Mr. Chen Juilin, was held responsible for the
loss and arrested and charged with fraud and failure to
report losses.
  The largest purchaser of jet fuel in the Asia Pacific
region and the key supplier of imported jet fuel to the
civil aviation industry of China.

 By 2000 it obtained 92% market share of jet fuel

imported to China’s civil aviation industry.

Company
 Enjoying monopoly in the market the following years
Overview showed a marked increase in the profits of the
company.

 CAO started its option trading in 2002. Initially, CAO

used to deal only in derivatives of futures and swaps to
hedge its jet fuel market risk.
  In the mid 2003, in order to strengthen its profile in the
market, CAO started trading in speculative derivative
options.

 Originally, CAO took a bullish view of the jet fuel market.

Summary  Predicting that the market price of jet fuel would continue
its upward trend, CAO took a long position in the market,
and sold puts and bought calls.

 CAO gained from the exercise of call options and from the
premium of put options; this strategy yielded enormous
profit for CAO in the first three quarters of 2003.
  By the end of 2003, CAO revised its strategy to a
bearish stance.

 The CEO signed contracts with several banks, buying

put options and selling call options.

Summary  The prices soared well above the strike price of the call
of $38 and CAO faced a large deficit.

 Despite mark to market losses of $30 million by mid

2004, the CEO increased the bet in the hope that the
jet fuel prices would eventually decline and the
premium could be used to cover the losses.
  The jet fuel price continued its upward trend and by
October 2004, the mark-to-market losses increased to
$180 million.

 By November 2004, when the losses had mounted to

$550 million, CAO was required to meet the margin
Summary requirements but was not completely successful in
doing so.

 CAO was trying to compensate for their existing losses

by collecting premiums on options that had the
potential to generate further losses in the future.
Event
Overview
Reporting
 1. Poor level of corporate governance
 Little experience in derivative market
 Lack of proper risk management system
Analysis  Lack of time and expertise
 Unreliable accounting
 Ignorance of stop loss estimation
2. Poor accounting system
 Lack of proper evaluation and analysis
 Accounting without considering fair value
 Not for complex options
 Accounting errors
  Better control and enhancement of risk management
system
 An independent risk management department
 Experts to manage risk
 Early warning systems
Learning  Following best financial accounting system
 Transparency
 Simulating stress testing
 Gather optimum information and knowledge before
entering the market
  https://www.academia.edu/7517127/PROCTER_and_GAMBLE_EX
PENSIVE_LESSON
 https://www.nytimes.com/1994/10/28/business/p-g-sues-bankers-
trust-over-swap-deal.html
References  https://financetrain.com/bankers-trust-case-study/
 https://financetrain.com/risk-management-case-study-
metallgesellschaft-ag-mgrm/