A swap in simpler terms means an exchange. In financial term, a swap is a derivative (a contract which derives its value from an underlying asset or security), in which two parties exchange cash flows for each party’s financial instruments. Generally, one party pays the cash flows at a fixed interest rate, while the other party pays at floating rate basis. A callable swap would be when the party which pays fixed cash flows gains the right to terminate the swap at one or more pre-determined times before the swap matures. Thus callable swap is a type of cancellable swap.
An investor is likely to choose a callable swap to invest in when interest rates are expected to change and it would affect the fixed rate payer negatively. Since the callable swap gives a party to terminate the swap before the maturity period, it the fixed interest rate is higher and is thus it is more expensive than a regular swap. But it has its own advantages:
a. Protection against fluctuating interest rates
b. No upfront premium
c. Customized and flexible in accordance with both the parties
There are two types of callable swaps: European Style and Bermudan Style callable swap. In a European style callable swap, the fixed rate payer gets just one time right to end the swap (example- a ten year European style swap, callable after one year– gives the fixed rate payer the right to terminate the swap only at the end of year once), whereas, in a Bermudan style callable swap, he gets specific timelines to terminate the swap (a ten year Bermudan style swap callable after year two and every six months after that. This option gives the fixed rate payer the right to terminate at the end of year one, and also at the end of every six months after the first year).