What is a Callable Swap?

A callable swap is a type of swap. Swaps are deals between two groups. They agree to exchange, or “swap”, one thing for another in the future. Often what they swap is cash flows. Cash flows are money that comes in or goes out.

The two main types of cash flows in a swap are fixed rate and floating rate. Fixed means the same amount each time, like $100 every month. Floating changes each time, based on prices in markets.

In a callable swap, two new ideas come in:

The group paying fixed rate gets a choice. After some time, they can end the swap early if they want to. This choice is called an option.
It is “over the counter”. This means the two groups make the deal directly. They don’t use an official exchange.

Paying Fixed, Receiving Floating

Most of the time in a callable swap:

One group agrees to pay a fixed rate, like 5% per year.
The other group agrees to pay a floating rate instead. The floating rate changes based on short-term interest rates.

The group paying fixed gets a special power in a callable swap. After an agreed time, like 2 years, they can end the swap whenever they choose. They “call” the swap to cancel it.

Why End a Swap Early?

The fixed rate side might want to get out of the swap because:

Short-term rates dropped a lot. The floating payments they get are now much lower than the fixed ones they pay. The swap costs them money.
They don’t need the swap anymore. Maybe they paid off a loan they got the swap for in the first place.
They found a new, better deal. They want to end this swap to do the new one instead.

An Example

Imagine two banks, Bank A and Bank B, do a 5-year callable swap.

Bank A agrees to pay Bank B a fixed rate of 5% per year.
Bank B agrees to pay Bank A a floating rate. It will be based on the 1-year Treasury rate plus 2%.

The swap has a “lockout” time of 2 years. After that, Bank A has the choice to end the swap at any time.

How the Swap Helps Bank A

Why would Bank A want this swap? A few reasons:

They have a 5-year loan paying a floating rate. The swap changes it to fixed 5%.
They think rates will drop. They want to lock in 5% before that happens.
They want the choice to end the deal. Rates might drop a lot in a few years. The option to cancel protects them.

How the Swap Helps Bank B

And why does Bank B agree to it?

They have to pay a fixed 5% on a bond they gave out. The swap changes that to a lower floating rate.
They think rates will rise, not fall. The floating rate they pay will be less than the 5% they get.
They charge Bank A extra for the cancel option. That fee makes the deal better for them.

After 2 Years Pass

Imagine after 2 years:

The 1-year Treasury rate falls to 1%.
So Bank B only pays Bank A 3% now (the 1% rate plus 2%).
But Bank A still pays 5% fixed to Bank B.

Bank A is losing 2% per year at this point. They might use their option to cancel the swap now. Then they can try to make a new swap at the new lower rates.

The Risk for Bank B

If Bank A cancels, Bank B loses out. They stop getting the 5% fixed rate from Bank A. Now they have to pay their bond at 5% without help.

This is the main danger of callable swaps for the floating rate side. The other group will end the swap when it helps them most and hurts you most.

Why Callable Swaps Exist

You might wonder why Bank B would take that risk. There are a few reasons callable swaps exist:

The fixed rate side pays extra for the cancel choice. That fee can make it worth it for the floating side.
Some groups need the floating rate. They will take the risk to get it. The fixed side might not do the deal at all without the cancel choice.
Both sides usually know a lot about rates. The floating side thinks the risk of the swap ending is low. Or that rates will rise, so they will gain more than they lose.
It’s a way to get swaps that last longer. The fixed side feels safer with a long swap if they can end it. The floating side wants a longer deal for the extra years of payments.

So callable swaps let groups do deals they might not do otherwise. The cancel choice has risks and costs. But it also makes some swaps possible in the first place.

Pricing the Cancel Risk

Since the cancel choice has value, figuring out the right price matters a lot. The floating side wants the fee to match the risk they are taking.

Banks use complex math to price the option. They look at:

Rates now and guesses for the future
How long until the swap can end
How rates vary and how fast they change
Other complex market actions

The fixed side wants the cheapest price that still makes the floating side agree. There can be a lot of back and forth to find a price both like.

The Callable Swap Market

Callable swaps are a common part of the swaps world. Swaps in total are a huge market, with over $500 trillion changing hands. Much of that comes from simple “plain vanilla” swaps. But large chunks use callable and other complex setups.

Only some groups use them:

Big banks on both sides of the deal
Governments and large companies as the fixed side
Hedge funds looking for special chances to gain
Groups that really understand the risks involved

Callable swaps are not for everyone. They are very complex with a lot of moving parts. Both sides need to know a lot about rates and markets to use them right.

Dealing Over the Counter

The “over the counter” part of callable swaps is important too. It means they aren’t traded on official exchanges. Instead, the two groups work directly to make the deal.

This has a few effects:

The groups can change the swap however they want. They can make it fit what they each need.
They just end a deal if there are issues. No exchange is there to fix problems.
There are fewer rules and less checking on each group. They have to trust that they each know what they’re doing.

Over the counter dealing adds some risk. But it also means more freedom to build swaps that really help each side.

Callable Swaps and the 2008 Crisis

Callable swaps played a part in the 2008 financial crisis. They didn’t cause the crisis. But they were one of many complex tools that added risk and confusion.

In the years before 2008:

Rates were very low for a long time
Many groups did callable swaps to get better rates
They thought rates would stay low
Home loan groups used them a lot to change their payments

When the crisis hit in 2007-2008:

Many home loans went bad as people missed payments
Rates moved fast and in big jumps
Many callable swaps were cancelled as groups struggled
This added even more trouble to already scared markets

Since then, rules on swaps are stronger. Every swap deal has to be reported. Groups have to keep more money saved in case of problems.

But callable swaps themselves are still common. And they still carry the same risks. The fixed side will cancel when it helps them and hurts the floating side.