A callable swap is a regular interest rate swap where one side has the right but not the obligation to terminate all future payments during the life of the swap.
There are two styles of callable swap, the difference between them being in when the swap can be called.
In a:
European style callable swap (also known as a cancelable swap), the swap can only be canceled on one specific date.
Bermudan style of callable swap, the swap can be canceled on any one of a number of predefined dates.
In addition there are two types of this swap, depending on who has the right to termination of the underlying swap:
If the payer has the right to terminate the swap on a number of dates, it is known as a callable swap. This is a combination of a vanilla swap and a receiver swaption.
If the receiver has the right to terminate the swap on a number of dates, it is known as a putable swap. This is a combination of a vanilla swap and a payer swaption.
There is no penalty for terminating the swap on the predefined date, but if the right to terminate the swap early belongs to the:
Payer the fixed rate is higher than that of the equivalent vanilla swap with the same start date, end date, etc.
Receiver the fixed rate is lower than that of the equivalent vanilla swap with the same start date, end date, etc.
The breakeven rate is based on a number of elements, including the time to the right to cancel and the interest rate volatility (higher volatility will lead to a larger difference in the breakeven rate between the callable swap and the equivalent vanilla swap).
Example of a European Callable Swap
In the example below, the fixed rate payer enters into a swap which gives the right to cancel to the other side in order to lower the fixed rate to be paid.
A floating rate borrower is considering converting that floating rate liability into a fixed rate liability, and is thus considering entering into a five year pay fixed swap as the fixed rate payer.
The current swap rate is 4.5%, but this borrower wishes to pay a lower rate. The borrower thus enters into a pay fixed swap cancelable by the other side, say, after the third year.
Because the other party has been given a right to cancel, the borrower is only required to pay a fixed rate of 4.2%. The downside for the borrower is that the other party may cancel the swap after three years.
If interest rates rise over the next three years, the other party is highly likely to cancel the swap when their (embedded) swaption is in the money. The borrower will therefore lose the protection that the swap provided.
Advantages of a Callable Swap
A callable swap (both styles) has the following advantages:
The swap can be cancelled without any penalties.
There is no premium to be paid upfront.
Often, however, an investor will sell a Bermudan callable swap instead of a European callable swap because of the higher coupon that will be received. The coupon is higher because the option being sold is more valuable—it can be cancelled on more than one date.
Pricing a Callable Swap in SDX Interest Rates
When pricing a callable swap in SDX Interest Rates, in addition to the standard fields that are specified for vanilla swaps you must also define the following:
Whether the swap can be canceled by the fixed rate payer or fixed rate receiver. You do this using the Callable <> Putable button.
Whether the callable swap is a Bermudan or European style.
For a Bermudan style, the call frequency.
The call dates.
The first call date is displayed in the First eff. call date field, and defines the first date on which the owner of the right to cancel can cancel the swap. By default this is set to match the start date of one of the underlying coupons.
For a European callable swap this is the only call date. For a Bermudan callable swap it is the first call date and the system sets the remaining call dates to the start dates of each of the remaining relevant coupon periods (according to the call frequency set).
You can see and edit the remaining call dates in the Callable Dates and Fees window. For more information on working with this window, see Working in the Callable Dates and Fees Window.
Also be aware that for a callable swap, the coupon start and end dates of the first leg must match the coupon start and end dates of the second leg.