What Is a Putable Swap?
A putable swap is a cancellable interest rate swap—containing an embedded put option—where one counterparty makes payments based on a floating rate, while the other party makes payments based on a fixed rate. The fixed-rate receiver (floating-rate payer) has the right, but not the obligation, to terminate the swap on a number of pre-determined dates prior to its expiration date.
The complement of a putable swap is a callable swap, where the fixed-rate payer has the right to end the swap early. Although many of the mechanics appear similar, a putable swap is not the same as a swap option, or swaption.
- A putable swap is a variation on an interest rate swap that contains an embedded put option giving the holder the right to cancel the contract at certain points over the life of the swap.
- The embedded put option effectively limits the impact from unfavorable interest rate moves in the future.
- The difference between the putable swap rate and the market swap rate is the implied cost of the embedded option.
Understanding a Putable Swap
Putable swaps give the party who is long the swap, and receiving the fixed rate, a chance to change their mind about receiving fixed interest rates. This right to cancel limits downside and protects against adverse rate movements in the future. But the tradeoff is a lower swap rate than they would receive with a traditional plain vanilla interest rate swap.
A putable swap might be attractive to an investor who thinks interest rates are going to rise and are therefore happy to receive a lower fixed rate of interest in exchange for the option to cancel. Should interest rates rise, the fixed-rate receiver can put the swap back to the issuer and then replace it with a plain vanilla swap at the now higher prevailing market rate.
A putable swap may also appeal to a buyer if they are uncertain about the life of the floating rate they will be receiving from an asset. This floating rate received from the asset is used to pay the floating rate on the putable swap. If the buyer's underlying floating revenue stream can be canceled, paid-out early, or converted to another rate, then a putable swap may be beneficial because the ability to cancel the swap allows the swap buyer to realign a new swap (if needed) with the underlying revenue stream.
Putable swaps trade over-the-counter (OTC) and are therefore customizable based on what the two parties involved agree on.
The Price of Putable Swaps
The additional features of putable swaps make them more expensive than plain vanilla interest rate swaps. The fixed-rate receiver pays a premium, either in the form of an upfront payment or a lower swap rate. There may also be a termination fee.
In general, the "cost" of a putable swap is the difference between the putable swap rate and the market swap rate. This difference depends on interest rate volatility (the more volatility, the higher the costs), the number of rights to cancel (the more rights, the higher the cost), the time to the first right to cancel (the more time, the higher the cost), and the shape of the yield curve.
Example of a Putable Swap
Assume that one party wants to buy a swap that pays them fixed interest rates. In exchange, they will pay a floating rate. They price out a vanilla interest rate swap and find that a buyer can receive 3% fixed interest, as well as pay the Fed Funds Rate plus 1%. The Fed Funds Rate is currently 2%.
The buyer is unsure if their floating rate underlying asset, which they are using to pay the floating rate, will continue; therefore, to help eliminate their risk, they opt to purchase a putable swap instead of a vanilla interest rate swap.
A putable swap is negotiated, but the buyer will only receive 2.8% fixed rate interest and will still need to pay the Fed Funds Rate plus 1%, which currently totals 3%. The 0.2% the buyer loses out on equates to the premium for being able to cancel the swap.
Should the buyer lose the floating rate they are receiving from the underlying asset, they can cancel the putable swap contract. If interest rates rise, the buyer may also want to cancel the swap and then initiate another swap to receive a higher fixed interest payment.