What it means
In a standard interest rate swap, two parties agree to exchange interest payments on a notional amount, most often one paying a fixed rate and receiving a floating rate. A callable swap adds a termination right on set dates, so the fixed rate payer can end the agreement without the usual settlement of its market value.
Cancellable swap and callable swap are both used to describe the same arrangement. The reason it exists is that hedges often outlive the thing they were hedging.
A borrower who fixes the rate on a loan and then repays the loan early is left holding a swap with no matching exposure, and unwinding it when rates have fallen means paying a break cost that can run into hundreds of thousands. A cancellation right removes that risk at a known, budgeted price.
The price is visible in the fixed rate quoted. A dealer will offer a plain swap at one rate and a callable version at a higher one, and the difference is the premium for the embedded option spread across the life of the deal.
Comparing that extra cost with the likely break cost is the whole decision. Analytically the instrument is just a combination of two things already familiar: a plain swap plus a swaption that offsets it.
Understanding it that way explains why the extra cost rises with the volatility of interest rates and with how long the cancellation right lasts. It also explains why dealers price it from their option books rather than from the swap curve alone.
The typical users are borrowers whose debt may not run its full term. Property developers who expect to sell assets, companies with prepayable bank loans and issuers of callable bonds all face the same mismatch, and a callable swap lines the hedge up with the uncertainty.
Where repayment is genuinely certain, the plain swap at the lower rate is the better buy.
In practice
Real-world examples.
Example
A property developer hedges a three year construction loan but expects to sell the completed building early. It pays 30 basis points extra for a callable swap, and when the sale completes eight months ahead of schedule it cancels the hedge at no cost.
Example
A company issues a callable bond and swaps the fixed coupon into a floating rate. Because the bond itself may be redeemed early, the treasurer matches it with a callable swap so that calling the bond and cancelling the swap can happen on the same date.
Example
A hospital group fixes the rate on a loan that allows prepayment from surplus donations. Donation income is unpredictable, so the finance director chooses the callable structure and explains the extra 25 basis points to the board as insurance against a break cost.
Formula
Calculation
Extra cost of the cancellation right = notional x (callable fixed rate - plain fixed rate) x number of years it runs; approximate break cost on a plain swap = notional x rate movement x years remaining
A developer needs a five year hedge on a notional amount of $20,000,000. A plain swap is quoted at a fixed rate of 3.90% and the callable version at 4.25%, a difference of 0.35%, which costs 20,000,000 x 0.0035 = $70,000 a year. If the deal runs the full five years the cancellation right will have cost 70,000 x 5 = $350,000. Now suppose the underlying loan is repaid at the end of year three, when market rates have fallen by one percentage point with two years left to run. Breaking a plain swap would cost roughly 20,000,000 x 0.01 x 2 = $400,000, whereas the callable swap is simply cancelled after three years of extra cost totalling 70,000 x 3 = $210,000, a net saving of 400,000 - 210,000 = $190,000.Case study
Seen in the real world.
Sablebrook Property Partners is an illustrative, fictional developer that financed a mixed-use scheme with a $35,000,000 floating rate loan and was required by its bank to fix the rate. The plain swap was offered at 4.10% and a version cancellable from year two at 4.45%.
The extra 0.35% cost 35,000,000 x 0.0035 = $122,500 a year. Sablebrook expected to sell two of the three buildings within thirty months, which would trigger partial repayment, so it accepted the higher rate. In the fictional outcome the sales completed in month twenty-eight, rates had fallen, and cancelling the swap cost nothing where breaking the plain version would have cost an estimated $780,000.
The illustrative lesson the partners drew was that the cancellation right was worth buying precisely because their repayment date was uncertain. On a later project with a fixed ten year tenant and no prepayment right, they chose the cheaper plain swap instead.
Watch out
Common mistakes.
- Comparing only the headline fixed rates and choosing the plain swap, without putting a figure on the break cost the cancellation right avoids.
- Assuming the cancellation right works both ways, when it normally belongs to one named party on specified dates only.
- Buying the flexibility for a loan that cannot be repaid early anyway, which pays for an option that can never be used.
Questions
People also ask.
Is a callable swap the same as a swaption?
Not quite, because a swaption is a standalone option to enter a swap, while a callable swap is a live swap with a termination option attached.
Why would a bank offer this structure at all?
Because it charges for the embedded option through the higher fixed rate and manages the resulting exposure across its wider book of trades.
Does cancelling early create an accounting gain or loss?
Cancelling on a contractual date avoids a settlement payment, but any amounts previously deferred under hedge accounting still have to be released to profit or loss.
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