The callable inverse floater is a regular Inverse Floater Swap where the payer of the structured coupon has the right but not the obligation to terminate the deal on one or more predefined dates during the life of the deal. It is essentially a combination of an inverse floater swap and a receiver swaption.
The payer of the structured coupon will cancel the swap when it expects the specified interest rate index to keep dropping (which would result in the adjustable rate increasing). In exchange for this right to cancel the swap, this party will agree to a higher fixed rate in the inverse floater formula.
Pricing a Callable Inverse Floater Swap in SDX Interest Rates
You price a callable inverse floater swap in SDX Interest Rates in the same way as you would price an inverse floater swap (see Pricing an Inverse Floater Swap in SDX Interest Rates). However, for a callable inverse floater swap it is important to note that:
By default the system sets the call dates to match the start dates of the underlying coupons using the call frequency.
In the Callable Dates and Fees window (accessed by clicking the Call Dates button in the pricing page) you can then edit the notice dates, and also cancel any of the automatically scheduled call dates. For more information on working in this window, see Working in the Callable Dates and Fees Window.
The fixed rate for the inverse formula leg is displayed in the Market Rate result in the Results area. When you calculate the instrument the system automatically calculates the fixed rate for you. Alternatively you can define it manually.
Advantages of a Callable Inverse Floater Swap
An issuer would enter into this instrument as a hedge (or swap) against callable debt.
An investor enters into this instrument to enhance yield. That is because, in order to compensate for the risk that the other party may cancel the swap (as well as the risk embedded in the coupon formula) the interest rate is preferential to the rate that would be received on a vanilla investment. For example, in the callable inverse floater the payer of the structured leg will agree to a higher fixed rate.
Disadvantages of a Callable Inverse Floater Swap
The disadvantages of a callable inverse floater swap are as follows:
If interest rates in the market improve from the point of view of the investor, the payer of the structured leg will call the swap and the investor will then have to enter into another investment with a less favorable interest rate.
If interest rates in the market worsen from the point of view of the investor, the investor is locked into receiving these lower coupons.