What is Modified Following?
Modified following is a facet of date rolling that occurs when a contractual transaction day falls on a holiday. If this occurs the date is usually pushed forward or backward so that it coincides with a business day. When contracts are signed between parties in different regions with different banking days, then modified following is applied according to the holidays of whichever party is making the payment as they will require banking services to initiate the transaction.
Understanding Modified Following
An example of modified following is the business day convention. This implied rule states that if the payment date on a swap or other contractual transaction does not fall on a banking day, the modified following date will be the next banking day. The exception to the rule is if the banking day extends into a new month; in this case, parties will use the banking day that precedes the payment date.
Modified Following and Swaps
A swap is an example of a contractual agreement in which a payment date could be changed as per the terms of modified following. A swap is a derivative contract; in this contract, two parties exchange financial instruments, generally involving cash flows based on a notional principal amount.
Each cash flow comprises of one leg of the swap. One cash flow is generally fixed, while the other is variable (e.g. based on a benchmark interest rate). Swaps do not trade on exchanges. Instead, swaps are over-the-counter contracts between businesses or financial institutions, so a payment date is agreed upon among both parties as part of the contract. If the payment date falls on a holiday, modified following could push it to ahead or back in time so that it does fall on a business day, and the contract completes.
Modified Following and Bank Holiday
Modified following is sometimes required if a transaction is set to occur on a bank holiday. While bank holidays and stock market holidays do not always coincide, either could make it difficult for payment to take place.
In 2019, U.S. bank holidays are as follows: January 1 (New Year’s Day), January 21 (Martin Luther King Day), February 18 (President’s Day), May 27 (Memorial Day), July 4 (Independence Day), September 2 (Labor Day), October 14 (Indigenous People’s Day), November 11 (Veteran’s Day), November 28 (Thanksgiving Day), and December 25 (Christmas Day).
Of these, five switch days every year: Martin Luther King Day, President's Day, Memorial Day, Labor Day, Indigenous People’s Day, and Thanksgiving Day. So modified following makes it easier to manage contractual payments of derivatives without explicitly listing every payment date and the exceptions within a contract.