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Introduction to Variable Maturity Swaps

As set out in Bermudan Swaptions, issuance of Bermudan swaptions is often motivated by the desire to construct cancellable and extendible swaps. Thus, provision of appropriate valuation routines for the swaptions means that little extra effort is required to deal with cancellable swaps.

Cancellable or puttable swaps are instruments that give the fixed rate payer the option to terminate the swap on a set of pre-specified future dates. For the counterparty that has 'bought' the cancellable swap, the deal can be decomposed into the following two constituent parts:


A vanilla interest rate swap with the right to pay fixed and receive floating.


A purchased receiver swaption that exercises into a swap with the same terms and conditions of the vanilla swap component. That means that if the swaption is exercised, the counterparty will receive fixed cashflows and pay floating cashflows that exactly offset the payments from the vanilla swap. The original vanilla swap is therefore effectively cancelled.

Both cancellable swaps can be valued based on their decomposition into the appropriate Vanilla Swaps and Bermudan Swaptions. No further detail is therefore needed here.


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