What is a Cancellable Swap?
It is a Swap that may be cancelled by the Borrower at no cost on an agreed date in the future. It is structured as a combination of an Interest Rate Swap and a Receiver’s Swaption, where the cost of the Swaption is embedded into the fixed rate of the Swap and the Swaption’s strike is chosen such that it is the same as this fixed rate.
It enables the Borrower to protect their borrowing costs for a defined period of time whilst retaining the opportunity to cancel the contract on an agreed date or dates in the future without the potential burden of penalty costs. It is particularly useful if the Borrower anticipates an early termination of the underlying Loan.
How does it work?
The Borrower has a contractual requirement to pay a fixed rate of interest and receive the floating rate (i.e. three month LIBOR) under the Swap. The Receiver’s Swaption provides the Borrower with the option to enter into a Receiver’s Swap (receive the fixed rate and pay the floating rate) to negate the effect of the Payer’s Swap thus enabling the whole structure to be terminated at no cost to the Borrower.
- It provides the Borrower with a known fixed rate of interest
- It provides the Borrower with the opportunity to cancel the contract on a future date at no cost
- No upfront cash premium is required
- The fixed rate for a Cancellable Swap will be higher than that for a comparable (vanilla) Interest Rate Swap