What is the formula method?
The formula method is used to calculate termination payments for a swap contract that terminates prematurely, whereby the terminated party compensates for losses borne by the non-terminated party due to early termination (that is, before its expiration). ).
The formula method can be compared to the other two acceptable termination payment strategies, the other two being the settlement value and indemnity methods.
- The formula method is used to calculate the termination payments due on a swap contract that has ended before expiration.
- The goal is to compensate the non-guilty party due to the early termination.
- The formula method calculated the damages owed to the not-at-fault party by the at-fault party in the early termination of a swap by following a simple calculation or formula.
- The formula itself must be agreed by each counterpart at the beginning of the swap contract and detailed in its termination clause.
- The other two accepted methods for calculating termination payments, as established by ISDA, are the “settlement value method” and the “indemnity method.”
Understand the formula method
The formula method was introduced to establish a clear methodology for calculating termination payments on a prematurely terminated swap, rather than an ad hoc, case-by-case tabulation. Termination payments are used to compensate the party that did not cause the swap to terminate early for its financial loss, or opportunity cost, for terminating the agreement before the stated expiration date. Generally, currency swaps use the formula method, although it is still one of the less common methods for calculating early termination payments for a swap.
Of the three official methods for calculating termination payments established by the International Swaps and Derivatives Association (ISDA), the “deal value method”, which is based on the terms available for a replacement swap, is the most common. . The third method, the compensation method, is also not used frequently. A swap can be terminated early if a termination event occurs, such as an illegality, a tax event, a tax event after a merger, or a credit event. A case of default, such as bankruptcy or non-payment, can also lead to early termination.
Exchange agreements entered into by two counterparties are often considered legally binding financial contracts, which have a predetermined expiration date. However, certain events may cause an early termination before the stated expiration date. If such an event is suspected to have occurred, the early termination should be assessed and the obligations of one of the swap parties to the other should be calculated through the three methods sanctioned by ISDA.
The formula method calculated the damages due to the not-at-fault party by the at-fault party in the early termination of a swap by following a simple calculation, or formula, which must be agreed upon by the two counterparties at the start of the transaction. swap contract through termination clause. However, the formula method was never standardized, which led to the development of other better accounting methods, thus limiting the use of this method to calculate swap early termination payments.
Other early swap cancellation methods
The “indemnification method” requires the at fault counterparty to compensate the not at fault counterpart for all losses and damages caused by early termination. This method was common when swaps were first developed, but has since been deemed inefficient as it did not actually quantify, or describe how to quantify, the actual losses and damages incurred by a prematurely terminated swap.
The “settlement value method” is based on the cost of initiating a replacement exchange transaction, since the not-at-fault counterparty did not cause the early termination and therefore may need to enter into a replacement exchange with a different counterparty. . Replacement swaps are used to calculate termination payments because changes in market conditions since the initial (now terminated) swap was entered will mean that the terms of that swap may not apply or may even be unavailable. Therefore, the replacement swap will likely have different terms and different interest rates. This method is the most common rollback for an early swap termination.