Cancellable swaps

Cancellable swaps—which can be cancelled by one party prior to the scheduled termination date. For example, the party with the cancellation right may elect to do so if he or she was the fixed-rate payer and... 

One answer to this problem is for the investor to use a cancellable swap instead of a vanilla swap. Suppose that the investor is interested in a 5-year swap, cancellable by the investor after three years. This can be structured by combining ... 

The combination of the below-market swap and the payer s swaption therefore creates a cancellable swap. Erom the investor s viewpoint, he or she can now compare ... 

A cancellable swap paying 2.60% fixed for five years, but giving the investor the free right to cancel the swap after three years if he or she chooses. 

For the calculation, we cancel out the principal payments of par at maturity. We assume that cash flows are annual and take place on the same coupon dates. The breakeven asset-swap spread A is calculated by setting the present value of all cash flows equal to 0. From the perspective of the asset swap seller, the present value is ... 

If 2-year rates rise sufficiently in 3-years time, the swaption will expire in-the-money, and the investor can exercise the payer s swaption, entering into a second swap as the fixed-rate payer at exactly the same rate as the original swap, for which the investor is the fixed-rate receiver. This second swap exactly offsets the first swap, effectively cancelling the original swap for the last two years of its life. 

If 2-year swap rates are higher than 2.60% in three years time, the investor would cancel the original swap, and either enter into another swap at a better rate, or enjoy the higher floating rate from the FRN. 

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