Understanding the Volatility Exposure in Cancellable Swaps

Summary

The document explains a cancellable interest rate swap from the perspective of a dealer that pays fixed and has the right to terminate. It represents the cancellable structure as a vanilla swap combined with an option to enter an offsetting swap. This option changes the economics compared with a plain swap and helps explain why the fixed rate may be higher when the dealer holds the cancellation right.

The cancellation feature allocates volatility exposure between the parties. In the stated case, where only the fixed-rate-paying dealer can cancel, the dealer is buying volatility and receives protection if interest rates fall, in exchange for paying a higher fixed rate. Which party buys or sells volatility depends on who controls termination. The explanation describes the option component and its trade-off; it does not provide a valuation method, quantify potential profit, or establish that the dealer expects rates to move in a particular direction.

Key ideas

• A cancellable swap can be viewed as a vanilla swap combined with an option on an offsetting swap.
• The right to cancel changes the swap’s value and may be reflected in a higher fixed rate.
• The party controlling cancellation determines how volatility exposure is allocated.
• A fixed-rate payer with the sole cancellation right is described as buying volatility.
• The cancellation right protects that payer if rates fall, but the explanation does not quantify profitability.

Tags

# How do swap dealers make money from trading cancellable swap?


# How do swap dealers make money from trading cancellable swap?












A fixed-rate payer (e.g. a swap dealer) of a cancellable swap pays more interest than he receives because he has the right to terminate the swap after a certain time if rates fall. What are the reasons the swap dealer trades this kind of product? Does he expect interest rate will rise in the future and then the received cash flows will be more than the fixed rate payment? And the right to terminate the deal is just a kind of "insurance" for him to stop loss if the rates do not move up or even fall? How can he make money from trading this kind of deals?

## Answer by Lliane (score 1)

https://quant.stackexchange.com/a/42992

You can see a cancellable swap as the combination of a vanilla swap and an option to enter a swap in the opposite direction. Depending on who can cancel the swap (dealer, counterpart or both), the swap dealer is buying or selling the volatility to the counterpart.

If the swap dealer is the fixed rate payer and only him can terminate the deal (which seems to be your example), he is actually buying volatility and will pay a higher fixed rate than a vanilla swap, while having a protection if interests were to fall.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.