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Name and outline termination events and review how they could affect the parties to a transaction.

FRM® Part II · Credit Risk Measurement and Management · Netting, Close-out and Related Aspects · FRM2.CR.16.f

The idea

Under an ISDA Master Agreement, two kinds of events can end transactions early. Events of Default (Section 5(a)) involve fault by one party. They are failure to pay or deliver, breach of agreement, credit support default, misrepresentation, default under a specified transaction, cross default, bankruptcy and merger without assumption. Termination Events (Section 5(b)) involve no fault. They are illegality, force majeure, tax event, tax event upon merger, credit event upon merger, and additional termination events agreed in the Schedule, such as a rating downgrade or a net asset value decline. In each case the affected parties are identified and the transactions are closed out and netted at market value. The non-affected party can use a termination event as an option, ending the trades when it is in the money. For the exam, classify the event first. Fault means Event of Default, no fault means Termination Event, and a merger where obligations are assumed but credit quality is weaker is a Credit Event Upon Merger.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following is a Termination Event, as opposed to an Event of Default, under the ISDA Master Agreement?

  1. Failure to Pay or DeliverWhy not: An Event of Default under Section 5(a), involving fault by one party.
  2. Illegality - correct
  3. BankruptcyWhy not: An Event of Default under Section 5(a), involving the failure of one party.
  4. Cross DefaultWhy not: An Event of Default under Section 5(a), triggered by default on other borrowing.

Termination Events under Section 5(b) involve no fault: illegality, force majeure, tax event, tax event upon merger, credit event upon merger and additional termination events.

A harder one

A dealer's Schedule with a hedge fund says the dealer may terminate if the fund's net asset value falls 30 percent within a quarter. The fund's value falls 32 percent but it has missed no payment. How is the dealer's right classified?

  1. An Event of Default for breach of agreement, with the fund as the Defaulting PartyWhy not: No covenant was breached; a trigger agreed in the Schedule is a Termination Event.
  2. A Force Majeure event, because the market fall was beyond the fund's controlWhy not: Force majeure concerns events that prevent performance, not investment losses.
  3. A Credit Event Upon Merger, because the fund's credit quality has weakenedWhy not: There has been no merger, so Credit Event Upon Merger cannot apply.
  4. An Additional Termination Event, with the fund as the Affected Party, and no Event of Default has occurred - correct

Additional Termination Events are agreed in the Schedule and are Termination Events, so no fault is attributed; the dealer simply gains the option to terminate.

The hardest tier

Bank X has an additional termination event: if X is downgraded below BBB, its counterparty Y may terminate. X is downgraded. Y closes out all four trades under one agreement, valued to Y at +40, -18, -12 and +15 (USD million), and holds USD 10 million of collateral posted by X. Closest to the net amount X must pay Y is:

  1. USD 15 million - correct
  2. USD 25.0 millionWhy not: Ignores the collateral Y already holds and pays the full net claim.
  3. USD 35.0 millionWhy not: Adds the collateral to the net claim instead of subtracting it.
  4. USD 45.0 millionWhy not: Ignores close-out netting: sums the positive values (55) and then subtracts the collateral.

Net close-out value = 40 - 18 - 12 + 15 = 25 in Y's favour. Y already holds 10 of collateral, so the cash X must pay is 25 - 10 = 15.

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