Posted in Finance, Accounting and Economics Terms, Total Reads: 664
Definition: Putable Swap
Let us understand what is swap is in the first place, a swap is an exchange of future cash flows. The most popular forms include foreign exchange swaps and interest rate swaps. They are used to hedge volatile rates, such as currency exchange rates or interest rates.
So now to putable swap, the common form of swap is a put option. A put option gives its holder the right ( but not an obligation ) to sell an asset for a specified price on or before a specified expiration date. For example, let us see how interest rate swap works.
Consider a firm (Company A) that has issued bonds (which, remember, means essentially that it has taken loans) with a total par value of $10 million at a fixed interest rate of 8 percent. By issuing the bonds, the firm is obligated to pay a fixed interest rate of $800,000 at the end of each year. In a situation like this, it can enter into an interest rate swap with another party (Company B), where Company A pays Company B the LIBOR rate (a floating, or variable, short-term interest rate measure) and Company B agrees to pay Company A the fixed rate. In such a case, Company A would receive $800,000 each year that it could use to make its loan payment. For its part, Company A would be obligated to pay $10 million x LIBOR each year to Company B. Hence Company A has swapped its fixed interest rate debt to a floating rate debt. (The company swaps rates with Company B, called the counterparty. The counterparty gains because presumably it wants to swap its floating rate debt for fixed rate debt, thus locking in a fixed rate). So as it is a putable swap, the company B has the right to terminate the deal before it matures.