Hedging floating rate term-loan with a participating interest rate swap
Scenario analysis
Disclaimer: For accredited product advize ask your bank or treasury advisory partner.
The simulation below with fictious data is for illustrative purposes only.
What is a participating interest rate swap?
A participating interest rate swap offers a flexible and cost-effective solution for managing interest rate risk in mid-market companies such as commercial real-estate, manufacturing, social housing etc.
By combining the characteristics of interest rate swaps and caps, this financial product (ask your bank or treasury advisory partner for accredited product advise) enables mid-market treasurer to fine-tune their interest rate risk profiles. By allocating a portion of the debt to a traditional interest rate swap (pay fix, receive floating) and the remaining portion to a interest rate cap, companies can strike a balance between hedging obligations with a fixed rate and protecting against potential interest rate increases.
The degree of participation, or the extent to which the cap is utilized, is determined by the proportion of the debt allocated to it. Furthermore, the integration of the cap premium into the swap rate streamlines the hedging process and eliminates the need for separate premium payments, resulting in cost savings. The carefully aligned embedded swap rate and cap strike rate ensure a hybrid and efficient risk management strategy.
Using participating interest rate swaps
Why?
This hedge safeguards borrowers with floating rate loans from potential increases in short-term interest rates, while also allowing them to capitalize on potential rate decreases
How?
Example: Hedging a floating rate loan with a participating interest rate swap
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Advantages of the participating interest rate swap
Interest Rate Certainty
The borrower enjoys peace of mind by knowing the maximum interest rate they’ll pay on their hedged loan.
Potential for Lower Costs
If floating interest rates decrease, the borrower can benefit from lower financing costs.
Enhanced Financial Flexibility
This strategy empowers the borrower to manage cash flows more effectively by providing greater flexibility in their financial planning.
No Initial Investment
The product requires no upfront premium, making it an attractive option for borrowers seeking to hedge their interest rate risk without additional upfront costs.
Disadvantages of the participating interest rate swap
Typically higher Swap Rate
The participating swap rate associated with this product is typically (due to the embedded cap premium) higher than the standard market swap rate.
Limited Upside Potential
If floating interest rates remain below the cap strike rate throughout the term of the cap, the borrower may not realize significant benefits from the hedge.
Potential Termination Costs
Early termination of the hedge, especially in a low-interest-rate environment, could result in substantial termination costs on the swapped portion of the debt.
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