Can a Party Still Use Internal Models to Determine the Close-Out Amount under the 2002 Isda? ▴ Question

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The Protocol of Economic Equivalence

The 2002 ISDA Master Agreement represents a foundational protocol for the over-the-counter derivatives market, establishing a standardized architecture for contractual relationships. Within its framework, the mechanism for calculating a “Close-out Amount” upon an early termination event is of paramount importance. This process is designed to distill the economic essence of all terminated transactions into a single net payment, ensuring the non-defaulting party achieves the “economic equivalent” of the performance it was due had the transactions run their full course.

The 2002 Agreement deliberately moved away from the more rigid, prescriptive valuation methods of its 1992 predecessor, introducing a more flexible and principles-based approach. This evolution grants the Determining Party ▴ typically the non-defaulting party ▴ significant discretion in its calculation methodology.

At the heart of this updated protocol is the mandate that the Determining Party must act in good faith and use “commercially reasonable procedures in order to produce a commercially reasonable result.” This standard is the critical fulcrum upon which the entire valuation process balances. The agreement explicitly allows for a wide array of information to be used in this calculation. This includes, but is not limited to, quotations from third parties for replacement transactions, relevant market data, and, significantly, information derived from internal sources. The inclusion of internal sources as a permissible input is a direct acknowledgment that for many complex or illiquid derivatives, a true market price may be elusive, and a party’s own sophisticated modeling may provide the most accurate and reliable valuation.

The 2002 ISDA Master Agreement’s Close-out Amount calculation provides a flexible, principles-based framework for achieving the economic equivalent of terminated transactions, expressly permitting the use of internal models.

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Internal Models as a Permissible Valuation Input

The explicit sanctioning of internal data and models within the 2002 ISDA Master Agreement’s text is a direct answer to the core question. A party can indeed use its internal models to determine the Close-out Amount. The framework permits the use of “quotations and relevant market data from internal sources (including affiliates) of the Determining Party used in the regular course of its business for the valuation of similar transactions.” This provision is a pragmatic recognition of the realities of modern finance, where institutions develop and rely on sophisticated proprietary models for pricing, hedging, and risk management across their portfolios.

The use of these models is not, however, an unrestricted right. The flexibility granted by the 2002 Agreement is paired with a higher standard of conduct. The Determining Party’s procedures and the resulting amount are subject to an objective test of commercial reasonableness. This contrasts with the standard under the 1992 Agreement, which was often interpreted as requiring only a rational basis for the decision.

The shift to an objective standard means that a court reviewing a disputed close-out calculation will assess whether the procedures and outcome were reasonable from the perspective of a neutral market participant, not just from the subjective viewpoint of the Determining Party. Therefore, while internal models are a valid tool, their application must be rigorous, well-documented, and capable of withstanding external scrutiny.

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Strategy

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Navigating the Commercial Reasonableness Standard

The strategic decision to employ an internal model for calculating a Close-out Amount hinges on a deep understanding of the “commercial reasonableness” standard. This is not a vague aspiration but a concrete legal threshold that has been shaped by significant court decisions. The flexibility afforded by the 2002 ISDA Master Agreement is a powerful tool, yet its use demands a disciplined and defensible strategy.

The Determining Party must construct a valuation process that is not only internally consistent but also externally validatable. The core strategic objective is to produce a valuation that is robust enough to withstand a potential legal challenge by demonstrating a clear, logical, and evidence-based approach.

Landmark cases, such as those arising from the Lehman Brothers default, have provided critical guidance. Courts have scrutinized the methodologies used by non-defaulting parties, establishing that “commercially reasonable” implies an objective standard. A Determining Party’s calculation will be judged on whether the procedures were objectively reasonable and designed to produce an objectively reasonable result.

This means a party cannot simply assert that its internal model is accurate; it must be prepared to demonstrate why it is accurate and appropriate for the specific transactions being terminated. The strategy, therefore, must be one of meticulous documentation and justification at every step of the process.

A successful strategy for using internal models in ISDA close-outs requires a meticulously documented process that can objectively demonstrate commercial reasonableness to a third-party observer.

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A Comparative Framework for Valuation Methodologies

Choosing to use an internal model is a strategic decision that should be made after considering the available alternatives. The 2002 ISDA Agreement allows for various inputs, and the most appropriate choice depends on the nature of the terminated transactions and the prevailing market conditions. A comparative analysis reveals the distinct advantages and challenges of each approach.

Valuation Input	Primary Use Case	Key Advantages	Strategic Challenges
Third-Party Quotations	Liquid, standardized products (e.g. plain vanilla swaps).	High degree of objectivity; strong evidence of market value.	May be unavailable in distressed markets or for illiquid/complex products; obtaining multiple quotes can be slow.
Third-Party Market Data	Products with observable inputs (e.g. options priced off a liquid underlying).	Objective inputs; verifiable against market sources.	The model using the data may still be subjective; data may be sparse for certain parameters (e.g. long-dated volatility).
Internal Models & Data	Complex, bespoke, or illiquid derivatives where external quotes are unavailable or unreliable.	Can value any transaction; leverages existing risk infrastructure; can be executed quickly.	Higher burden to prove commercial reasonableness; potential for perceived bias; requires extensive documentation and justification.

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Factors Influencing the Choice of Methodology

The decision-making process for selecting a valuation methodology is a critical component of a firm’s risk management framework. The following factors must be systematically evaluated:

Transaction Complexity ▴ For highly structured or exotic derivatives, internal models are often the only viable method for capturing the nuances of the product’s payoff structure. Relying on external quotes for such instruments may be impossible or lead to commercially unreasonable results.
Market Conditions ▴ During periods of extreme market stress or illiquidity, obtaining reliable third-party quotations can be exceedingly difficult. In such scenarios, the 2002 ISDA Agreement explicitly permits a party to use internal sources if it reasonably believes external data is not readily available or would produce a result that is not commercially reasonable.
Availability of Data ▴ The robustness of an internal model is contingent on the quality of its inputs. A firm must assess whether it has access to sufficient and reliable market data to power its models. Where key inputs are unobservable, the assumptions used must be clearly articulated and justified.
Documentation and Transparency ▴ The choice to use an internal model must be accompanied by a commitment to transparency. The firm must be prepared to provide the counterparty with a statement showing, in reasonable detail, the calculations performed, including the key inputs and assumptions from the internal sources used.

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Execution

Operationalizing the Defensible Valuation Process

The execution of a Close-out Amount calculation using an internal model is a high-stakes operational procedure that demands precision and foresight. The primary goal is to create a complete, auditable trail that substantiates the commercial reasonableness of both the process and the outcome. This is not merely a quantitative exercise; it is the construction of a body of evidence.

The process must be systematic, with clear governance and controls to mitigate the risk of a successful legal challenge. A failure in execution can lead to costly disputes and significant financial loss.

The foundation of a defensible process is the principle of objectivity. Even when using an internal model, the Determining Party must strive to operate as a neutral agent seeking the fair economic value of the terminated transactions. This involves applying models and data consistently with how they are used in the regular course of business for valuing similar transactions.

Any deviation from standard practice must be documented and justified by the specific circumstances of the close-out. The execution phase must be viewed as preparing a case for an impartial arbiter from the very first step.

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Procedural Checklist for Internal Model Valuation

A robust operational playbook for executing a close-out valuation via an internal model should incorporate the following critical steps:

Initial Assessment ▴ Immediately following the Early Termination Date, the responsible team must assess the portfolio of Terminated Transactions. This involves identifying the complexity of each trade and evaluating the prevailing market conditions to determine the most commercially reasonable valuation methodology. The decision to use an internal model, and the rationale for it, must be formally documented.
Model Selection and Validation ▴ The specific internal model(s) to be used must be identified. These should be the same models used for the firm’s regular portfolio valuation and risk management. Evidence of the model’s prior validation, including its theoretical soundness, calibration to market data, and any known limitations, should be compiled.
Data Sourcing and Verification ▴ All market data inputs required by the model must be sourced as of the Early Termination Date (or the subsequent date(s) if commercially reasonable). The source of each piece of data (e.g. internal, third-party vendor) must be recorded. Any data that requires cleaning, interpolation, or the use of proxies must have the methodology for doing so clearly documented.
Execution of Calculation ▴ The valuation model is run using the verified data. The full results, including all inputs, assumptions (e.g. volatility surfaces, correlation matrices), and the final calculated value for each transaction, must be securely archived.
Independent Review ▴ A qualified individual or group within the firm, independent of the individuals who performed the initial calculation, should review the entire process. This review should cover the appropriateness of the model, the accuracy of the inputs, and the overall commercial reasonableness of the result.
Preparation of the Statement ▴ A detailed statement must be prepared for the counterparty. As required by the ISDA Master Agreement, this statement must show the calculations in reasonable detail, including the quotations, market data, and information from internal sources used. It should be clear enough for the counterparty to understand the basis of the determination.

Executing a close-out valuation with an internal model requires a rigorous, multi-step process that emphasizes documentation, independent validation, and transparent communication to the counterparty.

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Illustrative Close out Calculation and Documentation

To demonstrate the level of detail required, consider the documentation for the close-out of a single complex derivative, such as a cross-currency swap with an embedded option. The supporting documentation provided to the counterparty would be expected to contain a table similar to the following.

Valuation Component	Source / Model	Key Inputs	Result (USD)
Fixed Leg (USD)	Proprietary Discount Curve Model	USD OIS curve as of ; Bloomberg Ticker ▴	+ 5,250,000
Floating Leg (EUR)	Proprietary Discount Curve Model	EURIBOR 3M forward curve as of ; Reuters RIC ▴	– 4,800,000
FX Conversion	Internal FX Rate Feed	EUR/USD spot rate at 4:00 PM London time on ▴ 1.0850	– 5,208,000
Embedded Option	Proprietary Stochastic Volatility Model	Implied Volatility Surface (Source ▴ Internal Trading Desk); Correlation Matrix (Source ▴ Historical Data)	+ 750,000
Credit Valuation Adjustment	Internal CVA Model	Counterparty CDS spread ▴ 250bps (Source ▴ Markit); Internal funding cost curve	– 150,000
Net Close-out Amount	Sum of Components	N/A	+ 642,000

This level of transparency, while not revealing the proprietary code of the model itself, provides the counterparty with a clear view of the constituent parts of the valuation and the sources of the data used. It forms the basis of a commercially reasonable procedure by allowing the other party to replicate and verify the calculation using their own tools and data, thereby reducing the likelihood of a dispute.

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References

International Swaps and Derivatives Association. (2002). 2002 ISDA Master Agreement. ISDA Publications.
Flavell, A. (2010). The Interest Rate Swap Market. In Swaps and Other Derivatives (pp. 1-26). John Wiley & Sons, Ltd.
Mengle, D. (2007). Close-Out Netting. ISDA Research Note.
Firth, A. (2018). Lehman Brothers Special Financing Inc. v National Power Corporation & Anor EWHC 487 (Comm). Journal of International Banking and Financial Law.
Gregory, J. (2020). The xVA Challenge ▴ Counterparty Credit Risk, Funding, Collateral, and Capital. John Wiley & Sons.
Cont, R. (2005). Model uncertainty and its impact on the pricing of derivative instruments. Mathematical Finance, 16(3), 519-547.
Brigo, D. & Mercurio, F. (2006). Interest Rate Models – Theory and Practice ▴ With Smile, Inflation and Credit. Springer Finance.
Hull, J. C. (2021). Options, Futures, and Other Derivatives. Pearson Education.

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The Valuation Protocol as a Systemic Capability

The ability to determine a Close-out Amount under the 2002 ISDA Master Agreement is more than a legal or quantitative task; it is a reflection of an institution’s entire risk management architecture. The choice to use an internal model is a declaration of confidence in that system’s capacity to produce a fair and defensible measure of economic reality, even under duress. The framework of “commercial reasonableness” compels an institution to look inward at its own processes, not as isolated calculations, but as an integrated system of models, data feeds, and governance. How robust is this system?

Is it designed with the necessary controls and transparency to withstand the scrutiny that follows a counterparty default? The knowledge gained through understanding these protocols is a component in a larger system of institutional intelligence, where a superior operational framework provides the ultimate strategic edge.