What is a Participating Swap?
A Participating Swap is a contractual agreement between two counterparties, the Borrower and the Bank, to exchange interest payments on a pre-agreed profile. It is constructed by the combination of an interest rate Swap and an interest rate Cap where a pre-agreed portion of the notional amount is hedged with a Swap and the remaining portion is hedged with a Cap. The degree of participation is determined by the proportion attributable to the Cap and the instrument is rendered zero cost by embedding the Cap premium into the Swap rate. The instrument is structured in such a way that the embedded Swap rate and the Cap strike rate are set at the same level.
To provide the Borrower with protection, at a maximum rate, against rising short-term interest rates but retain the opportunity for the Borrower benefit in a low short-term interest rate environment on the capped portion (the participation).
How does it work?
If, on any reset date, the floating rate (i.e. three month LIBOR) is below the fixed rate, then the Borrower will pay the fixed rate of interest in return for a floating rate of interest on the portion covered by the Swap. On the capped portion, the Borrower will pay the floating rate subject to a maximum determined by the Cap. If the floating rate is above the fixed rate (strike rate), the Borrower receives the difference between the fixed rate and the floating rate on both the swapped and capped portions of the debt, ensuring a maximum cost of funds as the fixed rate (strike rate) of the Participating Swap.
- It provides the Borrower with the comfort of a known maximum rate of interest on 100% of the hedged debt
- It provides flexibility to benefit from low prevailing floating rates on the capped portion of the debt
- It provides the Borrower with greater flexibility in managing cash flows
- No upfront premium is payable
- A Participating Swap Rate will be higher than the market swap rate
- If the floating rate fails to rise above the Cap strike rate during the tenor of the Cap, the Borrower may feel that no value was received
- Potential termination costs are payable on the swapped portion of the debt should the hedging be terminated early in a low rate environment
Participating Interest Rate Swap example: