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 beneficiary (floating rate payer) has the right, but not the obligation, to terminate the swap on a number of predetermined 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 terminate the swap early. Although many of the mechanisms seem similar, a putable swap is not the same as a swap option or a swaption.
Key points to remember
- A puttable swap is a variation of an interest rate swap that contains an embedded put option giving the holder the right to cancel the contract at certain times during the life of the swap.
- The embedded put option effectively limits the impact of adverse interest rate movements in the future.
- The difference between the puttable swap rate and the market swap rate is the implied cost of the embedded option.
Understanding a putable swap
Puttable swaps give the party that is long on the swap and receives the fixed rate, a chance to change their mind about receiving fixed interest rates. This cancellation right limits declines and protects against adverse rate movements in the future. But the trade-off is a lower swap rate than they would receive with a traditional vanilla interest rate swap.
A puttable swap could be attractive to an investor who thinks interest rates will rise and is therefore happy to receive a lower fixed interest rate in exchange for the cancellation option. If interest rates rise, the fixed rate beneficiary can return the swap to the issuer and then replace it with a plain vanilla swap at the now higher prevailing market rate.
A puttable swap can also attract a buyer if they are unsure of the life of the variable rate they will receive 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 income stream can be canceled, prepaid, or converted to another rate, a puttable swap may be advantageous because the ability to cancel the swap allows the buyer of the swap to realign a new swap (if necessary) with the underlying income stream.
Putable swaps are traded over-the-counter (OTC) and are therefore customizable depending on what both parties involved agree on.
The price of putable swaps
The additional features of putable swaps make them more expensive than vanilla interest rate swaps. The beneficiary of the fixed rate pays a premium, either in the form of an upfront payment or a lower swap rate. There may also be termination fees.
In general, the “cost” of a puttable swap is the difference between the puttable swap rate and the market swap rate. This difference depends on the volatility of interest rates (the more volatility, the higher the costs), the number of termination rights (the more rights, the higher the cost), the obtaining the first right of termination (the longer it is, the higher the cost), and the shape of the yield curve.
Example of a putable exchange
Suppose a party wants to buy a swap that earns him fixed interest rates. In exchange, they will pay a variable rate. They price 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 federal funds rate is currently 2%.
The buyer does not know if his floating rate underlying asset, which he uses to pay the floating rate, will continue; therefore, to help eliminate their risk, they choose to buy a putable swap instead of a plain vanilla interest rate swap.
A puttable swap is negotiated, but the buyer will only receive 2.8% fixed rate interest and will still have to pay the fed funds rate plus 1%, which currently totals 3%. The 0.2% the buyer loses equals the premium to be able to undo the trade.
If the buyer loses the floating rate he receives from the underlying asset, he can cancel the putable swap contract. If interest rates rise, the buyer may also wish to cancel the swap and then initiate another swap to receive a higher fixed interest payment.