Callable Swap

What Is a Callable Swap?

A callable swap is a contract between two counterparties in which the exchange of one stream of future interest payments is exchanged for one more in view of a predefined principal amount. These swaps typically include the exchange of the cash flows from a fixed interest rate for the cash flows of a floating interest rate.

The difference between this swap and a customary interest rate swap is that the payer of the fixed rate has the right, yet not the obligation, to end the contract before its expiration date. One more term for this derivative is a cancellable swap.

A swap where the payer of the variable or floating rate has the right, yet not the obligation, to end the contract before expiration is called a putable swap.

How a Callable Swap Works

There is little difference between a interest rate swap and a callable swap other than the call feature. Notwithstanding, this directs an alternate pricing mechanism which accounts for the risk the payer of the floating rate must take. The call feature makes it more costly than a plain vanilla interest rate swap. This cost implies the fixed rate payer will pay a higher interest rate and potentially need to pay extra funds to purchase the call feature.

Albeit a large number of the mechanics are comparative, a callable swap isn't equivalent to a swap option, which is better known as a swaption.

Why Use a Callable Swap?

An investor could pick a callable swap on the off chance that they anticipate that the rate should change in a manner that would adversely influence the fixed rate payer. For instance, assuming the fixed rate is 4.5% and interest rates on comparative derivatives with comparative maturities fall to maybe 3.5%, the fixed rate payer could call the swap to refinance at that lower rate.

Callable swaps frequently accompany callable debt issues, particularly when the fixed rate payer is more interested in debt cost as opposed to the maturity of that debt.

One more motivation to utilize this derivative is to safeguard against the early termination of a business arrangement or asset. For instance, a company gets financing for a factory or land at a variable interest rate. They may then try to lock in a fixed rate with a swap in the event that they accept there is a chance it will sell the financed asset right on time due to a change in plans.

The extra cost of the call feature is like a insurance policy for the financing.