Cancellable Swap
A cancellable swap is a type of interest rate swap in which one party has the option to terminate the swap before the agreed-upon maturity date. This feature gives the party the right, but not the obligation, to cancel the swap, hence the name “cancellable swap.”
In a typical cancellable swap, one party pays a fixed rate of interest while receiving a floating rate of interest from the other party. The floating rate is usually based on a benchmark interest rate, such as LIBOR. The fixed rate is determined at the time the swap is entered into, and it remains the same throughout the life of the swap.
The option to cancel the swap can be valuable to the party with this right, as it allows them to terminate the swap if market conditions change in their favor. For example, if interest rates decline, the party with the cancellation option may choose to cancel the swap and enter into a new swap at a lower fixed rate of interest.
The party with the right to cancel the swap usually pays a fee for this option. This fee is known as the cancellation fee and is paid to the counterparty, who is giving up the right to receive fixed-rate payments for a specific period.
Cancellable swaps are primarily used by corporate treasuries and financial institutions to manage interest rate risk. They can be customized to meet specific hedging needs and can be used to hedge against interest rate movements in a specific time frame.
Like other types of interest rate swaps, cancellable swaps are traded over-the-counter (OTC) and are not exchange-traded. This means that they are customized contracts between two parties, and there is no standardized contract or exchange where they are traded.