Callable Swap

Did you ever trade clothes with a friend or sibling because you liked theirs better? And later they took it back? That's kind of what a callable swap is all about.

Two parties make a contract where one set of fixed interest payments is exchanged for the cash flows of a variable interest rate. All are based on a specific principal amount with an expiration (maturity) date. What makes it a callable swap (versus a plain vanilla swap) is that whoever ends up with the fixed interest rate has the right (but not the obligation) to end the contract at any time before the agreed upon date. Because the holder of the variable rate is incurring more risk (interest rates might actually go up or down), a callable swap is more expensive for the fixed rate holder.

Let's say Call Me Handy Inc. receives private financing at a variable interest rate from Borrow Today Pay Tomorrow Inc. in order to build a new factory. When overall interest rates start to go down, they decide to swap that variable rate for a fixed interest rate. Call Me Handy thinks there might be a chance they will sell the factory early, and might decide to end the swap before the maturity date, thus calling in the swap.