What it means
The ISDA master agreement is the standard contract used by banks and companies for over-the-counter derivatives such as swaps. It sets out events that allow the contract to be closed out, and it separates them into events of default and termination events.
An event of default is about misbehaviour or failure, for example not paying on time. A termination event is about circumstances, such as a law change, a tax change, or a merger that weakens a party's credit, where nobody has necessarily done anything wrong.
When a termination event happens, the party who is not affected, or sometimes either party, can give notice and set an early termination date. The remaining transactions are then valued and closed out.
The valuation produces a single net amount, which is paid by one side to the other. This calculation takes the market value of every terminated trade, adds the positives, subtracts the negatives, and leaves one figure to be settled.
Finance teams care because a termination event can force a company to settle a position at a time not of its choosing. If the position has moved against the company, it may owe a large payment, and the hedge it relied on disappears.
Because the consequences can be large, many treasurers negotiate the schedule to the master agreement with care. They may add extra termination events, such as a drop in credit rating or a breach of a loan covenant, or they may ask for longer notice periods.
These choices should be reviewed with a lawyer.
In practice
Real-world examples.
Example
A manufacturer has an interest rate swap with a bank. A new tax law makes payments under the swap subject to a withholding tax, which is a tax deducted at source. This is a tax event, and the manufacturer may choose to terminate the swap. The bank calculates a close-out amount and the parties settle it.
Example
Two companies have a currency swap. One of them merges with a much weaker business, so its credit quality falls sharply. The other party can invoke a credit event upon merger and ask to end the trades. The weaker party might negotiate additional collateral instead of ending the deal.
Example
A government introduces a rule that bans a type of derivative with foreign counterparties. The contracts become illegal to perform, so an illegality termination event arises. Both sides close out the trades at their market value. The deal ends cleanly because neither party is blamed.
Formula
Calculation
Net close-out amount = sum of values of trades in favour of Party A - sum of values of trades in favour of Party B
Two swaps are terminated. Swap 1 is worth $2,000,000 to Party A, and Swap 2 is worth $500,000 to Party B.
Net close-out amount = 2,000,000 - 500,000 = $1,500,000
Party B pays Party A $1,500,000 to settle everything in one payment.Case study
Seen in the real world.
Harbor Lights Energy is an illustrative, fictional utility that used swaps to fix the interest rate on a $100,000,000 loan. A new regulation made it unlawful for its foreign bank to continue the swaps.
The treasurer received a notice of an illegality termination event. The swaps had gained value as rates fell, so the bank owed the utility a net close-out amount of $3,200,000.
The treasurer used the payment to cover part of the cost of replacing the hedge with a new bank. The illustrative lesson is that a termination event can arrive without any fault, so companies need a plan to replace a hedge quickly. Harbor Lights also changed its policy so that every new hedge is arranged with at least two banks, which makes replacement quicker.
Watch out
Common mistakes.
- Treating a termination event as the same thing as an event of default, when no wrongdoing is needed. A termination event can arise with no fault by either party, which is what separates it from a default.
- Assuming that the company will always receive money on close-out, when a losing position can mean a large payment. A close-out is a payment of the net market value, which can run in either direction.
- Ignoring the additional termination events that were negotiated into the schedule, which can include credit triggers. Read the schedule to the master agreement, where extra events are usually added.
Questions
People also ask.
What are common termination events?
Illegality, a tax event, a tax event upon merger and a credit event upon merger are typical examples. The list in the contract can be longer than the standard events, because parties are free to agree extra ones.
Who calculates the close-out amount?
The party entitled to do so, using market quotations or its own valuation methods, in line with the contract. Where a contract allows it, the parties may use a neutral dealer poll or an agreed method to value the trades.
Can a company protect itself?
Yes, by negotiating the schedule, watching its credit triggers and holding a list of backup hedging counterparties. A written plan for replacing hedges within a few days is a sensible precaution.
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