What it means
A swap is a contract in which two parties agree to exchange payments, for instance a fixed interest rate for a floating one. Banks and companies often have dozens of swaps with the same counterparty, and writing a full contract for each would be slow and expensive.
A master agreement solves this by putting the general terms in one document, signed once. The most widely used form is the ISDA Master Agreement, published by the International Swaps and Derivatives Association, and each later deal is confirmed with a short note that refers back to the master.
The agreement is usually accompanied by a schedule, where the parties customise terms, and often a credit support annex, which sets out the collateral each side must post as deals move in or out of the money. These documents turn a collection of separate trades into a single legal relationship.
The central benefit is close-out netting. If one party defaults, the parties calculate the value of all transactions, offset the positives against the negatives and end up with one net amount payable by one side, instead of each trade being settled separately.
The parties also agree what happens if something goes wrong. The master agreement lists events of default, such as failure to pay or bankruptcy, and termination events, such as a change in law, and says how the early-termination amount is to be calculated.
This reduces credit risk and therefore capital requirements, because exposure is measured on the net figure, not on the sum of the gross amounts. Its effectiveness depends on whether netting is enforceable in the relevant legal systems, so banks usually obtain legal opinions for each country in which they trade.
In practice
Real-world examples.
Example
A manufacturer signs a master agreement with its bank before taking out an interest rate swap to fix its loan costs. Later it adds a currency swap under the same master, with only a short confirmation needed. The legal team no longer has to renegotiate default and termination wording for every deal.
Example
A large bank has thousands of derivative deals with a hedge fund. Under the master agreement, if the fund defaults, the bank values all of them and claims only the net amount owed. The credit team uses that net figure when setting its limit for the fund.
Example
A pension fund and a dealer include a credit support annex in their master agreement so that the party whose position is out of the money posts collateral each day, limiting the build-up of exposure. The collateral is recalculated every day, so a large market move triggers an additional transfer quickly.
Formula
Calculation
Net exposure with netting = Sum of all transaction values owed to you - Sum of all transaction values you owe (if positive)
A company has three swaps with one bank under a master agreement. At the time of the bank's default, the swaps are worth +$5,000,000, -$3,000,000 and +$2,000,000 to the company.
Without netting, the company would be owed $5,000,000 + $2,000,000 = $7,000,000 on two swaps and would owe $3,000,000 on the other, and might have to pay the full amount it owes while claiming as an unsecured creditor for what it is owed. With netting, the net amount is $5,000,000 - $3,000,000 + $2,000,000 = $4,000,000 owed to the company, so its exposure is reduced by $3,000,000.Case study
Seen in the real world.
Calder Freight is an illustrative, fictional shipping company that used a handful of swaps to manage fuel costs and interest rates. Each swap was documented separately with different terms for default and termination, and the finance team struggled to track what would happen if a bank failed.
The new treasurer persuaded the board to sign master agreements with its two main banks. All existing and future swaps were brought under the same set of terms, and a credit support annex set limits on the collateral to be posted.
The treasurer's exposure report, which had been a long spreadsheet of gross numbers, was reduced to one net figure per bank. In this illustrative story the company found that its true exposure to each bank was about 40% lower than the sum of its trades suggested, and that its auditors found the reporting easier to verify. The treasurer then set internal limits by bank, using net numbers, and reported them to the board each quarter.
Watch out
Common mistakes.
- Assuming a master agreement is a single swap, when it is a framework contract covering many transactions that may be added over many years.
- Skipping the schedule or credit support annex, which contain the negotiated terms that actually matter in a dispute, such as collateral thresholds and additional events of default.
- Assuming netting always works, when its enforceability depends on the law that applies to the parties.
Questions
People also ask.
What is the ISDA Master Agreement?
It is the most widely used standard contract for over-the-counter derivatives, published by a trade body for the industry.
Why does netting matter?
It reduces the amount at risk if a counterparty defaults, which lowers credit risk and the capital a bank must hold, and in practice makes more trading possible with the same limits.
Does each trade need its own contract?
No, each trade is documented in a confirmation that refers to the master agreement, which saves time and keeps the terms consistent.
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