Can a Determining Party Use Only Its Internal Models to Calculate the Close out Amount under the 2002 Agreement?

Concept

The Principle of Economic Equivalence

The 2002 ISDA Master Agreement establishes a precise framework for terminating derivative transactions following a default. Central to this framework is the calculation of a “Close-Out Amount,” a single figure that represents the economic value of the terminated trades at a specific moment in time. The fundamental objective is to crystallize the net value of all future payment and delivery obligations that would have been exchanged had the transactions continued to their scheduled maturity.

This process ensures that the non-defaulting party, designated as the “Determining Party,” is restored to the same financial position it would have occupied in the absence of the default. The calculation is not a penalty; it is a mechanism designed to produce a fair and commercially reasonable valuation of the terminated portfolio’s economic equivalent.

This valuation paradigm replaced the more rigid “Market Quotation” and “Loss” methodologies of the 1992 agreement, which proved inadequate during periods of significant market stress. The Close-Out Amount introduces a more flexible and principles-based approach. It empowers the Determining Party to synthesize various sources of information to arrive at a valuation that reflects the prevailing market conditions.

The core tenet is that the non-defaulting party should neither be unduly enriched nor unfairly disadvantaged by the termination event. The entire process is anchored in the dual obligations of acting in good faith and employing commercially reasonable procedures to achieve a commercially reasonable result, a standard that elevates the process from a subjective assessment to one requiring objective justification.

The 2002 ISDA Agreement’s Close-Out Amount aims to provide the non-defaulting party with the precise economic equivalent of the terminated transactions.

Internal Models as a Permitted Valuation Input

The 2002 Agreement explicitly sanctions the use of internal data and proprietary models in the calculation of the Close-Out Amount. This provision acknowledges that for many complex, illiquid, or bespoke derivatives, a reliable external market price may not be readily available. In such scenarios, the Determining Party’s internal valuation systems, which are used in the regular course of its business for pricing and risk management, often represent the most sophisticated and reliable source of information. These models can incorporate a wide array of inputs, including yield curves, volatility surfaces, correlation matrices, and credit spreads, to generate a valuation for transactions that lack a liquid, observable market.

The inclusion of internal models as a valid input source was a deliberate evolution from the 1992 Agreement. It recognized that financial institutions develop and maintain complex valuation capabilities as a core part of their operations. Denying the use of these tools would force a reliance on potentially scarce or unreliable external quotes, particularly in dislocated markets where dealers may be unwilling to provide firm prices. By allowing their use, the agreement provides a pragmatic solution for valuing the entire spectrum of derivative products, from plain vanilla swaps to highly structured transactions.

However, this flexibility is not absolute. The use of internal models is always subordinate to the overarching principles of good faith and commercial reasonableness, meaning the models and their outputs must be defensible and aligned with how a reasonable market participant would assess the transaction’s value.

Strategy

The Strategic Decision to Employ Internal Models

A Determining Party’s decision to utilize its internal models for calculating a Close-Out Amount is a strategic one, balancing the need for accuracy and efficiency against the imperative of procedural integrity. The 2002 ISDA Master Agreement grants this flexibility, but its application demands a careful assessment of the prevailing circumstances. The primary justification for relying on internal models arises when external data is either unavailable, unreliable, or would fail to produce a commercially reasonable result. This situation frequently occurs with bespoke or long-dated derivatives, or during periods of systemic market stress when liquidity evaporates and third-party quotations become indicative rather than firm.

Employing internal models allows the Determining Party to leverage its own sophisticated risk and pricing systems, which are calibrated to its specific portfolio and used in its daily operations. This ensures consistency and can lead to a more accurate assessment of the “economic equivalent” of the terminated trades than relying on sparse or volatile external quotes. However, the strategy is predicated on the models being robust, well-documented, and consistent with industry standards. The Determining Party must be prepared to defend not only the final calculation but also the methodology and the inputs used.

This requires a transparent and auditable process, where the model’s assumptions are clear and the data sources are verifiable. The ultimate goal is to produce a valuation that is not just mathematically sound but also commercially defensible to the counterparty, and if necessary, to a court or tribunal.

A Determining Party must strategically justify the use of internal models by demonstrating that external market data is either unavailable or would not yield a commercially reasonable outcome.

Navigating the “commercially Reasonable” Standard

The cornerstone of the Close-Out Amount calculation is the obligation to use “commercially reasonable procedures in order to produce a commercially reasonable result.” This standard is objective, meaning the Determining Party’s actions are judged against those of a hypothetical reasonable market participant in the same situation. When relying solely on internal models, the burden of proof to meet this standard is significantly heightened. The Determining Party must construct a compelling narrative that justifies its departure from the implicit preference for third-party data.

Several factors are critical in this justification:

• Market Conditions ▴ Documenting the state of the relevant market at the time of the close-out is essential. Evidence of illiquidity, wide bid-ask spreads, or a lack of dealer participation can substantiate the claim that external quotes would be unreliable.
• Transaction Specificity ▴ For highly structured or non-standard transactions, it can be argued that no true external market exists. In such cases, internal models may be the only viable method for valuation.
• Model Integrity ▴ The internal models themselves must be sound. This involves demonstrating that they are consistent with models used for similar transactions in the normal course of business, are regularly back-tested and validated, and use market-accepted inputs where possible.
• Procedural Fairness ▴ The process should involve a degree of internal oversight, such as a review by a separate risk management or valuation control group. This helps to mitigate any perception of bias in the calculation.

Ultimately, the strategy is to create a comprehensive and contemporaneous record that explains the decision-making process. This documentation should articulate why external data was deemed inappropriate and how the chosen internal methodology produces a result that is fair, objective, and consistent with the principle of economic equivalence.

Execution

Operationalizing the Valuation Process

When a Determining Party concludes that it must rely exclusively on its internal models, the execution of the valuation process must be meticulous and procedurally robust. The objective is to create an unimpeachable audit trail that substantiates the final Close-Out Amount. This process begins with the formal designation of the Early Termination Date and the immediate gathering of all relevant transaction data for the terminated portfolio. A dedicated team, often comprising personnel from the trading desk, risk management, and legal departments, should be assembled to oversee the valuation.

The first operational step is to formally document the assessment of the external market. This involves recording any attempts made to obtain third-party quotes and noting the responses, or lack thereof. Market data vendors should be polled for relevant pricing information, and screenshots or data downloads should be archived. This evidence forms the foundation of the justification for using internal models.

Once this foundation is laid, the valuation can proceed using the firm’s approved, in-house models. Each transaction or group of transactions should be valued using the same models and inputs that the firm would use for its end-of-day marking and risk reporting. This consistency is a key requirement of the 2002 ISDA Master Agreement.

Executing a close-out using internal models requires a rigorous, documented process that justifies the exclusion of external data and validates the integrity of the chosen valuation methodology.

Model Inputs and Methodological Transparency

The credibility of a Close-Out Amount derived from internal models hinges on the quality and transparency of the inputs and the methodology. The Determining Party must be prepared to disclose the key components of its valuation to the defaulted counterparty. While the proprietary code of the model itself does not need to be shared, the inputs and assumptions must be clear and defensible.

The following table illustrates the typical data inputs for valuing a portfolio of interest rate swaps and currency options:

The methodology should also be transparent. For example, if a Monte Carlo simulation is used for a complex derivative, the number of paths and the underlying stochastic processes should be documented. If a Credit Valuation Adjustment (CVA) is applied, the basis for the probability of default and loss given default assumptions should be explained. This level of detail provides the counterparty with the necessary information to understand and replicate the calculation, which can pre-empt or resolve disputes.

Comparative Analysis and Justification

Even when relying solely on internal models, it is prudent to perform a comparative analysis to benchmark the results. This can involve comparing the model’s output to any available, albeit non-binding, indicative quotes, or to recent valuations of similar transactions. This internal stress-testing of the result adds another layer of validation to the process.

The following table provides a simplified comparison of valuation approaches for a hypothetical exotic derivative:

By documenting this type of comparative analysis, the Determining Party can demonstrate that it has considered all available information and has made a commercially reasonable choice to rely on its internal models. This proactive approach to justification is the most effective way to ensure that the Close-Out Amount is robust, defensible, and compliant with the letter and spirit of the 2002 ISDA Master Agreement.

Calibrating the Valuation Framework

The provisions of the 2002 ISDA Master Agreement provide a flexible, principles-based toolkit for the complex task of closing out derivative portfolios. The explicit allowance for internal models is a recognition of the sophisticated valuation infrastructure that underpins modern finance. Yet, this flexibility is not a grant of absolute discretion. It is a mandate to apply internal expertise within a framework of objective commercial reason.

The integrity of the close-out process, therefore, rests not on the models themselves, but on the governance and procedural discipline that surround their use. An institution’s ability to produce a defensible Close-Out Amount is a direct reflection of the robustness of its internal valuation control systems. This prompts a critical self-assessment ▴ is our valuation framework designed not only for the daily management of risk and P&L but also to withstand the intense scrutiny of a contentious default scenario? The answer to that question reveals the true strength of an institution’s operational architecture.