Putable Swap

A putable swap is a cancellable interest rate swap — with an embedded option — where one counterparty makes payments based on a floating rate, and the other party makes payments based on a fixed rate. The fixed rate receiver (floating rate payer) has the right, but not the obligation, to terminate the swap on a number of pre-determined dates prior to its expiration date. The opposite of a putable swap is a callable swap, where the fixed rate payer has the right to end the swap early.

Putable swaps give the party who is long the swap, who is receiving the fixed rate, a chance to change their mind about receiving fixed interest rates. This right to cancel limits downside, 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 plain vanilla interest rate swap.

Putable swaps can be used in asset-based swaps when the cash flow of the fixed-rate assets enabling the fixed-rate payments are uncertain. The cash flow from the asset would be uncertain if it is callable, such as a callable corporate bond, or a mortgage pass-through security where there is a risk of default or large prepayments if interest rates fall. For example, by canceling the swap, issuers of putable bonds can convert their rate exposure from fixed rate to floating rate in the event that the bonds are put by investors.

A putable swap might be attractive to an investor who thinks interest rates are going to rise, and are therefore happy to receive a lower fixed rate of interest in exchange for the option to cancel. Should interest rates rise, the fixed rate receiver can put the swap back to the issuer, and then replace it with a plain vanilla swap at the now higher prevailing market rate.

The additional features of putable swaps make them more expensive than plain vanilla interest rate swaps. The fixed rate receiver pays a premium, either in the form of an upfront payment or lower swap rate. There may also be a termination fee. In general, the "cost" of a putable swap is the difference between the putable swap rate and the market swap rate and depends on interest rate volatility (the more volatility, the higher the costs), the number of rights to cancel (the more rights, the higher the cost), the time to the first right to cancel (the more time, the higher the cost) and the shape of the yield curve. For more on how interest rate swaps are valued read, How To Value Interest Rate Swaps.