What is the Formula Method?

The formula method is used to calculate termination payments on a prematurely ended swap, where the terminating party compensates the losses borne by the non-terminating party due to the early termination.

Key Takeaways

  • The formula method is used to calculate termination payments on a prematurely ended swap, where the terminating party compensates the losses borne by the non-terminating party due to the early termination.
  • The formula method calculated damages owed to the not-at-fault party by the at-fault party in the early termination of swap by following a straightforward calculation, or formula, which must be agreed upon by the two counterparties at the initiation of the swap agreement via the termination clause.
  • The three official methods for calculating termination payments, as established by the ISDA, are "formula method," "agreement value method," and "indemnification method."

Understanding the Formula Method

The formula method was introduced to establish a clear methodology for calculating termination payments on a prematurely ended swap, rather than an ad hoc, case-by-case, tabulation. Termination payments are used to compensate the party who did not cause the swap to end early for its financial loss, or opportunity cost, for ending the agreement before its set expiration date. Typically, currency swaps will often use the formula method, though it remains one of the less common methods for calculating a swap's early termination payments.

Of the three official methods for calculating termination payments as established by the International Swaps and Derivatives Association (ISDA), the "agreement value method," which is based on the terms available for a replacement swap, is the most common. The third method, the indemnification method, is also not often used. A swap may be terminated early if a termination event such as an illegality, tax event, tax event upon merger, or credit event occurs. An event of default, such as bankruptcy or failure to pay, can also cause early termination.

Swap agreements undertaken by two counterparties are often considered legally binding financial contracts, which have a pre-determined expiration date. However, certain events can trigger an early termination before the stated expiration date. If such an event is suspected to have occurred, the early termination must be evaluated and the obligations of one party of the swap to the other figured out via the three ISDA sanctioned methods.

The formula method calculated damages owed to the not-at-fault party by the at-fault party in the early termination of swap by following a straightforward calculation, or formula, which must be agreed upon by the two counterparties at the initiation of the swap agreement via the termination clause. However, the formula method was never standardized, which led to the development of other, better accounting methods, thus limiting the usage of this method to calculate early swap termination payments.

Other Swap Early Termination Methods

The "indemnification method" requires the at-fault counterparty to compensate the not-at-fault counterparty for all losses and damages caused by the early termination. This method was common when swaps were first developed, but it has since been considered to be inefficient since it did not actually quantify, or describe how to quantify, the actual losses and damages incurred from a prematurely terminated swap.

The "agreement value method" is based on the cost for initiating a replacement swap transaction, since the not-at-fault counterparty did not cause the early termination and may thus need to enter into a replacement swap with a different counterparty. Replacement swaps are used to calculate termination payments because changes in market conditions since the initial (now-terminated) swap were entered will mean that the terms of that swap may no longer be applicable or even available. The replacement swap will thus likely have different terms and different interest rates. This method is the most common restitution for an early termination of a swap.