STRIPE: Understanding Interest Rate Risk Hedging with Participating Elements

What Is a Swap Transferring Risk With Participating Element (STRIPE)?

A swap transferring risk with participating element, or STRIPE, is a type of hedging instrument that combines an interest rate swap with an interest rate cap.

Key Takeaways

• A swap transferring risk with participating element (STRIPE) is a capped interest rate swap.
• It is used to hedge interest rate risk on an over-the-counter basis.
• The owner of the rate protection must pay an ongoing premium to the seller.
• An interest rate swap is a type of derivative whereby two parties agree to exchange interest payment streams or obligations.
• An interest rate cap is an agreement between a buyer and seller, whereby the buyer is guaranteed, in exchange for a recurring fee, that the interest rate paid on a financial instrument will be no more than the prescribed amount. 

Understanding Swaps Transferring Risk With Participating Element (STRIPE)

A swap transferring risk with participating element is a complex derivative strategy used by those looking to hedge interest-rate risk or profit from those looking to hedge interest-rate risk.

Derivatives are so-called because they are financial instruments whose value is derived from another instrument. In the case of an interest rate swap, the value of the swap is derived from the value of the debt instruments the contracts are written in reference to.

An interest rate swap is a type of derivative whereby two parties agree to exchange interest payment streams or obligations, while an interest rate cap is an agreement between a buyer and seller, whereby the buyer is guaranteed, in exchange for a recurring fee, that the interest rate it pays on a financial instrument will be no more than the prescribed amount. 

Special Considerations

Derivatives have been criticized by opponents of the financial services industry as mere instruments of speculation because they enable investors to make money or lose money based on the changes in the value of financial assets they don’t own.

Derivatives like credit default swaps (CDS) helped increase the severity of the 2008–09 financial crisis leading to the Great Recession because they endangered banks that sold insurance-like protection against the failure of other financial institutions, a setup that compounded the spread of financial contagion.

But not all derivatives or users of derivatives are made the same. There are legitimate uses of derivatives like interest rate swaps and interest rate caps, as when companies use these instruments to hedge interest rate risk.

Example of Swap Transferring Risk With Participating Element

Let’s say that the Philadelphia Widget Company borrowed $100 million in order to finance the construction of a new widget factory. It borrowed the money at a fixed rate of 5%, but since borrowing that money interest rates have started to fall. In order to lower its borrowing costs, the company buys a swap transferring risk with participating element, whereby it swaps its 5% payment with a bank for a variable rate loan of 4% that may fall even further from there.

At the same time, the STRIPE includes an interest rate cap, whereby the bank guarantees that if the interest rate begins to rise again, the Philadelphia Widget Company will pay no more than a 6% interest rate. The STRIPE enables the company to take advantage of falling rates while protecting itself against higher rates.