Formula Method (Swaps) - Explained
What is the Formula Method?
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Table of ContentsWhat is the Formula Method?How Does the Formula Method Work?Other Methods for Early Termination of Swaps
What is the Formula Method?
There are several methods for calculating termination payments, there is the Indemnification method, the agreement value method, and the Formula method as established by the International Swaps and Derivatives Association. The formula method is used for calculating termination payments on a prematurely ended swap. Termination payments are payments made to the party who was not responsible for the early termination of the swap .What may lead to early termination of a swap are:
- Tax event
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How Does the Formula Method Work?
A swap agreement is a financial contract between two parties for a specific period of time. IT usually has an expiration date. The agreement will include a termination clause since an early termination can be triggered by several events. The termination clause will state which of the three methods will be used to determine the obligations of the parties. The formula method is used to calculate the losses suffered by the party not at fault, this method is no longer in use in recent times, other better methods have been developed.
Other Methods for Early Termination of Swaps
Apart from the Formula method, there are still other methods namely;
- Indemnification Method
- Agreement Value method.
The Indemnification Method is when all the losses are being compensated by the responsible party to the other part based on the damage that resulted from the early termination of the swap. It is security against financial liability. This method has been overridden by the Agreement value method which put into consideration how to quantify the actual damages and interest rates. The Agreement Value method is an extensive method for the calculation of termination payments. It is calculated based on the cost of a replacement swap transaction, the changes in market condition and interest rates are put into consideration.