What Is the Indemnification Method?

The indemnification method calculates the termination payments when a swap is ended early and the holder has accepted an offer of pre♐paym✅ent.

The indemnification method can be compared with two other acceptable termination repayment strategies, wh♔ich are the formula and agreement value methods.

Understanding the Indemnification Method

The term 澳洲幸运5官方开奖结果体彩网:indemnity means protection against liability. The indemnification method requires the at-fault 澳洲幸运5官方开奖结果体彩网:counterparty to compensate๊ the resꦕponsible counterparty for all losses and damages caused by an early termination.

This method was common when swaps were first developed but was considered inefficient because it did not actually quantify, or describe how to quantify, those losses and damages from a prematurely terminated swap. Today, the "agreement value method," which is based on the terms and interest rates available for a replacement swap, is the most widely used method for calculating termination payments. Another less common alternative is the 澳洲幸运5官方开奖结果体彩网:formula method.

A swap is an agreement made between two counterparties to exchange cash flows (for example, 澳洲幸运5官方开奖结果体彩网:fixed-for-floating) along with 澳洲幸运5官方开奖结果体彩网:underlying currencies or other securities, such as commodities, terminating at a pre-determined date in the future. A swap contract may be terminated early if either counterparty experiences a 澳洲幸运5官方开奖结果体彩网:credit event or default, such as bankruptcy or failure to pay, or a termination event, such as an illegality, tax event, tax event upon a merger, or other contingency. The scope of what counts as an early termination event and how it will be sorted out will be made explicit in the swap's 澳洲幸运5官方开奖结果体彩网:termination clause.

History of the Indemnification Method

Initially, the indemnification method was used to make whole the counterparty who experienced a loss as the result of the other counterparty terminating the swap agreement early. Under this mꦓethod, the at-fault (terminating) party must make who🐟le (indemnify) the entire loss experienced by the other party due to the early termination.

However,♏ since it is not clear exactly how much money that counterparty will end up losing, both expl🌼icitly and in terms of opportunity costs, the formula method was introduced to establish a clear methodology for arriving at the indemnity amount, rather than it being an ad hoc tabulation.

Consequently, the formula method was itself replaced by the more commonly used agreement value method, which replaces the non-standardized formula for computing✨ a loss with a simple metric, ಞwhich is the cost of entering into a replacement swap. The replacement swap entails the new swap agreement that the injured counterparty would have to enter into in order to re-establish the original swap position.

However, since swap prices change over time and as interest rates and other factors fluctuate, the replacement contract may have different terms and market prices than the original swap. That difference in cost, to enter the new agreement with another counterparty, is the agreement value an✤d should indemnify the injured party.