A callable swap is a type of investment transaction that is structured to allow two parties to tender payments based on a different type of interest rate. One party will tender payments that are calculated using a specified fixed rate of interest while the other party in the arrangement provides payment that are based on a variable or floating interest rate that is tied back to the current average rate in the marketplace. The party who provides the payments based on the fixed interest rate has the ability to halt the swapping activity at any time before the investment reaches full maturity, effectively empowering that party to call the swap when and if desired.
One of the benefits of the callable swap is that the party making the fixed rate payments has the ability to call the swap if the prevailing interest rates move in a direction that would make the investment less advantageous for that investor. Should that movement lead to a situation in which that investor is actually losing money, he or she may decide to call the swap and prevent any further losses from occurring. At the same time, the investor paying the fixed rate can also choose to allow the swap to continue on toward the maturity date if the average interest rate is supporting what he or she is paying and allowing the arrangement to generate benefits.
Since a callable swap is basically a form of interest rate swap, setting the fixed rate of interest that will be involved in the deal is very important. Ideally, the goal is for each party to benefit from the arrangement in some manner. This can be difficult to do if the average rate of interest should suddenly swing far away from the fixed rate paid by one of the parties in the swap. For this reason, taking some time to carefully project what is likely to happen with the average rate over the duration of the swap and to identify a fixed rate that is considered equitable in light of those projections is extremely important.
A callable swap is different from a similar type of interest rate swap that is known as a potable swap. The latter still involves one party tendering payments based on a fixed rate while the other party issues payments based on a floating or variable rate. The difference with a potable swap is that it is the party who is paying the variable rate that has the ability to end the swap early if desired.
There are examples of a callable swap that do not allow investors paying based on a fixed interest rate to call the swap at will. When this is the case, there are usually specific dates over the life of the deal that are set aside for calling. This means that as those dates approach, the investor must assess the current status of the swap, decide if it is generating sufficient benefits to continue, and then either indicate that the swap will stand at least until the next cancel date or if it will end when the most recent call date arrives.