What is a Cancellable swap?

A cancellable swap is a special kind of swap deal. A swap is when two groups agree to trade something, like money, with each other. They decide ahead of time exactly how they will do the trade in the future.

What makes a cancellable swap different is that the two groups can decide later to stop the trade. Either group involved can choose to quit the deal on a future date that they pick when they first make the swap.

How cancellable swaps work

When two groups make a cancellable swap deal, they write down all the details of the trade they want to do later. This includes:

• What they will swap (trade), like different kinds of money
• How much they will swap
• When they will do the swap
• When either group is allowed to cancel (quit) the deal

The cancellable part is like an escape hatch. If something changes and the trade doesn’t seem like a good idea anymore, either side can pull the escape hatch and get out of the deal. But they can only do this on certain dates that they picked at the start.

Why groups use cancellable swaps

There are a couple main reasons why groups like banks or companies use cancellable swaps:

Manage risk

Swaps can help groups manage risk. For example, a company might use a swap to protect against big changes in exchange rates between different country’s money.

But what if things change a lot? The company might decide the swap is not needed anymore. Or that it costs too much to keep doing the swap.

With a cancellable swap, the company can quit the deal later. This lets them have the swap deal in place in case they need it. But they are not totally stuck if the swap stops being useful to them.

Make money

Groups like banks also use cancellable swaps to try to make money. They look for times when they think swap prices are not quite right.

For example, a bank might think that the cost to quit a swap is too low. They could buy that swap and hope that the cost to cancel it goes up later. Then they could sell the swap to another group for more than they paid.

The bank is betting that they can make money on the price difference over time. The cancellable part lets them get out of the deal if they need to. So it’s not quite as risky as a swap that you can never quit.

Downsides of cancellable swaps

Cancellable swaps have some negatives too:

More complex

Cancellable swaps are more complex than regular swaps. The added quit option makes them harder to understand and manage. Groups have to run numbers to figure out what all the possible outcomes are. Then they can decide if the cancellable swap is a good deal or not.

More expensive

The quit option in a cancellable swap is not free. Groups usually have to pay extra for the right to be able to cancel the deal later.

It’s like buying insurance. You pay a cost now for the ability to get out of the deal in the future if you need to. The more likely it is that you will want to cancel, the more expensive that cancel option will be.

How groups cancel a swap

If a group decides to use their option to cancel the swap, there are a few steps:

1. The group has to tell the other side that they are cancelling. There are official ways to send this message that the two groups agree on at the start.
2. The group cancelling usually has to pay a fee. This fee is part of the original deal. It’s often based on what current swap prices are at the time of the cancel.
3. Once the cancelling group pays the fee, the swap deal is done. Neither side has to do the trade they originally agreed to.
4. If neither group cancels, then the swap happens on the date that they picked at the start. They trade based on whatever prices and amounts they put in the original deal.

Real world example

An example can help make cancellable swaps more clear.

Pretend there are two companies, ABC Co and XYZ Inc. ABC is in the United States and uses US dollars. XYZ is in Europe and uses Euros.

ABC plans to buy supplies from XYZ in 6 months. The supplies will cost 1 million Euros. ABC is worried that the exchange rate between dollars and Euros will change a lot in the next 6 months. If the rate changes, the supplies might end up costing ABC a lot more in dollars than they planned on.

To protect against this, ABC makes a cancellable swap with Bank Q. In the swap, ABC agrees to pay Bank Q 1.1 million dollars in 6 months. In exchange, Bank Q will pay 1 million Euros to XYZ in 6 months.

The swap locks in the exchange rate for ABC today. They know exactly how many dollars they will need to buy the supplies.

But what if the exchange rate goes in a good direction for ABC? Then the swap might make the supplies more expensive instead of saving money.

That’s where the cancellable part comes in. For an extra $10,000 fee, ABC buys the right to cancel the swap in 3 months.

In 3 months, ABC looks at the latest exchange rates. If the rates moved so that the supplies would be cheaper without the swap, ABC can cancel the deal. They pay Bank Q the $10,000 cancel fee. Then ABC can buy Euros on their own at the better exchange rate.

If the rates moved so that the swap is still saving ABC money, they will keep the deal with Bank Q. The original swap will happen at the 6 month mark.

Either way, ABC has more control than with a normal swap. They have protection if rates go one way, and a way out if rates go the other direction.