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 another based on a specified principal amount. These swaps usually involve the transfer 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 regular interest rate swap is that the payer of the fixed rate has the right, but not the obligation, to end the contract before its expiration date. Another term for this derivative is a cancellable swap.

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

BREAKING DOWN 'Callable Swap'

There is little difference between an interest rate swap and a callable swap other than the call feature. However, this does dictate a different pricing mechanism which accounts for the risk the payer of the floating rate must take. The call feature makes it more expensive than a plain vanilla interest rate swap. This cost means the fixed rate payer will pay a higher interest rate and possibly need to pay additional funds to purchase the call feature.

Although many of the mechanics are similar, a callable swap is not the same as a swap option, which is better known as a swaption.

Why Use a Callable Swap?

An investor might choose a callable swap if they expect the rate to change in a way that would adversely affect the fixed rate payer. For example, if the fixed rate is 4.5% and interest rates on similar derivatives with similar maturities fall to perhaps 3.5%, the fixed rate payer might call the swap to refinance at that lower rate.

Callable swaps often accompany callable debt issues, especially when the fixed rate payer is more interested in debt cost rather than the maturity of that debt. 

Another reason to use this derivative is to protect against the early termination of a business arrangement or asset. As an example, a company secures financing for a factory or land at a variable interest rate. They may then seek to lock in a fixed rate with a swap if they believe there is a chance it will sell the financed asset early due to a change in plans.

The additional cost of the call feature is similar to an insurance policy for the financing.

RELATED TERMS
  1. Constant Maturity Swap - CMS

    In a constant maturity swap, the floating interest portion resets ...
  2. Foreign Currency Swap

    A foreign currency swap is an agreement to exchange currency ...
  3. Reverse Swap

    A reverse swap is an exchange of cash flow streams that undoes ...
  4. Interest Rate Swap

    An agreement between two parties (known as counterparties) where ...
  5. Currency Swap

    A swap that involves the exchange of principal and interest in ...
  6. Overnight Index Swap

    An overnight index swap is an interest rate swap involving the ...
Related Articles
  1. Managing Wealth

    An In-Depth Look at the Swap Market

    The swap market plays an important role in the global financial marketplace; find out what you need to know about it.
  2. Trading

    How To Value Interest Rate Swaps

    Interest rate swaps are derivative instruments that enable counterparties to exchange fixed and floating cash flows.
  3. Trading

    What Warren Buffet Calls "Weapons of Mass Destruction": Understanding the Swap Industry

    A full analysis of how the swap industry works.
  4. Investing

    How To Read Interest Rate Swap Quotes

    Puzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes
  5. Investing

    CFTC Probes Banks' Use of Interest Rate Swaps

    U.S. regulators are probing banks' trading and clearing of interest rate swaps, which played a central role in the 2008 financial crisis
  6. Investing

    The Advantages Of Bond Swapping

    This technique can add diversity to your portfolio and lower your taxes. Find out how.
  7. Investing

    Is Your Mutual Fund Safe?

    You might be carrying more risk than you think if your fund invests in derivatives.
  8. Managing Wealth

    Managing interest rate risk

    Interest rate risk is the risk that arises when the absolute level of interest rates fluctuate and directly affects the values of fixed-income securities.
  9. Investing

    Harvard Gets a Failing Grade on Interest-Rate Swaps

    Harvard is among scores of colleges and universities spaying the price for investing in interest-rate swaps that imploded during the financial crisis.
  10. Investing

    Callable CDs: Check The Fine Print

    These offer higher returns than regular certificates of deposit, but there's a catch.
RELATED FAQS
  1. When was the first swap agreement and why were swaps created?

    Learn about the history of swap agreements, the first swap agreement between IBM and the World Bank, and how swaps have evolved ... Read Answer >>
  2. What is the difference between derivatives and options?

    A derivative is a financial contract that gets its value from an underlying asset. Options offer one type of common derivative. Read Answer >>
  3. What are some examples of risks associated with financial markets?

    Find out about the different types of risks for different classes of assets including volatility, counterparty risk and default ... Read Answer >>
  4. Interest Rate Risk Between Long-Term and Short-Term Bonds

    Find out the differences and effects of Interest rates between Long-term and short-term bonds. Read how interest rate risk ... Read Answer >>
  5. How big is the derivatives market?

    Learn how different calculations can reduce the estimate of the total derivatives market by as much as 90 to 95%. Read Answer >>
Hot Definitions
  1. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  2. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  3. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  4. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  5. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  6. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
Trading Center