Abstract

In March 1994, Procter and Gamble Inc. charged $157m against pre-tax earnings, representing the losses on two interest rate swaps. One risk measure designed to warn against the potential of large losses is Value at Risk (VaR). In this article, I conduct a Value at Risk analysis of one of the swap contracts. The VaR analysis is based on a one-factor Heath-Jarrow-Morton model of the term structure. The calculated VaR is approximately seven times the value of the contract. A complementary measure of risk (the ‘conditional expected loss’) is about ten times the value of the contract. An interesting by-product that emerges is that the one-factor model captured the yield curve evolution during that time rather well.

Introduction

In this article, I study the riskiness of a leveraged interest rate swap contract. The contract, initially worth about $6.65m, experienced an extreme change in value over a short period of time in 1993–1994, leading to a loss of over $100M. While large losses in financial markets have a long and significant history, there has rarely been a period of time like the mid 1990s when a string of losses occurred in a variety of financial markets. Since then, considerable effort has been devoted to the development of risk measures to warn against the potential of such losses. One such measure is Value at Risk (VaR). In this article, I conduct a Value at Risk analysis of the contract. I am specifically interested in understanding whether VaR would have provided a warning that losses of the magnitude experienced were possible.