Define the ISDA (International Swaps and Derivatives Association) Master Agreement, together with the protections it gives against risk and the events of default it covers.
The idea
The ISDA Master Agreement is the standard contract that governs OTC derivatives between two parties. It is built from the printed Master Agreement, a Schedule that customises it, a Confirmation for each trade, and often a Credit Support Annex for collateral. All trades form a single agreement, which is what makes close-out netting work. On default the transactions are terminated and valued, and the positive and negative values are combined into one net amount owed. This keeps a liquidator from cherry-picking, keeping trades that favour the estate and abandoning the rest. Events of Default cover failure to pay, breach of agreement, credit support default, misrepresentation, default under specified transactions, cross-default, bankruptcy and merger without assumption. Illegality and tax events are Termination Events, where neither party is at fault. Exam point: netting is only as good as its legal enforceability.
Formulas
Loss on a defaulted netting set
Loss = max(ΣV, 0) × (1 − R)
- ΣV
- the sum of all trade values to the non-defaulting party under the agreement
- R
- the recovery rate on the net claim
Only where close-out netting is enforceable. Without it the liquidator can cherry-pick, the negative trades are paid in full and only the positive ones are claimed.
A practice question
What is the ISDA Master Agreement?
- A standard bilateral contract covering OTC trades, treating all trades as a single agreement - correct
- A rulebook published by an exchange that sets out the listed contracts and their margin requirementsWhy not: Describes an exchange or CCP rulebook, not a bilateral master agreement.
- A guarantee given by the association to compensate parties when a counterparty defaultsWhy not: The association publishes documentation; it does not guarantee any party's performance.
- A regulatory requirement that every derivative trade be reported to a trade repositoryWhy not: Confuses the contract with trade-reporting rules.
The ISDA Master Agreement, with its Schedule, Confirmations and Credit Support Annex, forms one agreement across all trades between two parties, which is what supports close-out netting.
A harder one
A dealer has three trades with a client under an ISDA Master Agreement with enforceable close-out netting. Their values to the dealer are +USD 14 million, -USD 9 million and +USD 3 million. The client defaults and recovers 40 percent of the claim. The dealer's loss is closest to:
- USD 10.2 millionWhy not: Ignores netting: applies the 60 percent loss rate to the sum of the positive values, 17 million.
- USD 3.2 millionWhy not: Uses the recovery rate as the loss rate: 8 x 0.40.
- USD 4.8 million - correct
- USD 8.0 millionWhy not: Nets the trades but ignores the recovery on the claim.
Net claim = 14 - 9 + 3 = 8 million. Loss = 8 x (1 - 0.40) = 4.8 million. Without netting the loss would be 10.2 million.
The hardest tier
A change in law makes it illegal for one party to perform its payment obligations under a transaction, through no fault of either party. Under the ISDA Master Agreement this is best described as:
- A no-fault Termination Event (Illegality), not an Event of Default - correct
- An Event of Default by the affected party, because it can no longer performWhy not: Treats inability to perform as fault; Illegality is a no-fault Termination Event.
- No event at all, because the contract continues until the law is changed backWhy not: Ignores the Termination Event provisions that allow termination of the affected transactions.
- A bankruptcy event, which automatically terminates every transaction between the partiesWhy not: Confuses illegality with bankruptcy; no automatic termination arises from a change in law.
Illegality, force majeure and tax events are Termination Events where no party is at fault, while Events of Default arise from a party's own failure or credit problems.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Derivatives
- Say what a derivative is and show how trading derivatives exposes a party to counterparty credit risk.
- Contrast the exchange-traded and over-the-counter (OTC) segments of the derivatives world, including how each market is structured.
- Outline how a derivative transaction is cleared.
- Name who takes part in derivatives collateralization and outline how collateral is used.
- Describe what credit derivatives look like and how they are employed, and discuss the risks that might stem from them.
- Describe how OTC derivatives are centrally cleared, and discuss the CCP (central counterparty) in terms of its roles, mandate, benefits and drawbacks.
- Account for the margin rules that apply to centrally-cleared derivatives and to those not centrally cleared.
- Say what SPVs, DPCs (derivatives product companies), monolines and CDPCs (credit derivatives product companies) are, and set out why they are limited as means of mitigating risk.
- Outline the methods for modelling derivatives risk and the difficulties met in doing so.