Can the Determining Party Use Its Own Internal Models to Calculate the Close out Amount Exclusively?

Concept

The Valuation Imperative in Counterparty Default

In the architecture of over-the-counter derivatives, the failure of a counterparty represents a critical system event. The immediate challenge becomes the accurate valuation of a complex web of terminated transactions to crystallize a final settlement figure. This figure, the Close-Out Amount, is the mechanism designed to restore the non-defaulting party to the economic position it would have occupied had the transactions proceeded as planned.

The core of the question is whether the designated “Determining Party” ▴ typically the non-defaulting entity ▴ can rely solely on its own internal valuation models to perform this critical calculation. This query touches upon a foundational tension within financial agreements ▴ the balance between procedural flexibility and the objective, verifiable fairness required to maintain market integrity.

The International Swaps and Derivatives Association (ISDA) Master Agreement, the governing protocol for the majority of OTC derivatives, provides the framework for this process. The 2002 version of this agreement introduced the “Close-Out Amount” concept, replacing the more rigid “Market Quotation” and “Loss” methodologies of the 1992 agreement. This evolution signifies a deliberate shift towards a more flexible and holistic valuation approach. The protocol grants the Determining Party considerable discretion, allowing it to use a range of information sources.

These sources include third-party quotes, relevant market data, and, significantly, information derived from its own internal models. The explicit inclusion of internal models acknowledges that for many complex or illiquid derivatives, a truly representative external market price may be unavailable or unreliable. In such instances, a well-calibrated internal model may offer a more accurate reflection of the transaction’s economic value.

The Close-Out Amount calculation is a critical protocol designed to produce the economic equivalent of the terminated derivative transactions, ensuring the non-defaulting party is made whole.

The Determining Party’s Mandate and Discretion

The role of the Determining Party is to calculate this Close-Out Amount. Under an Event of Default, this responsibility falls to the Non-defaulting Party. The ISDA framework empowers this party not just with the right to calculate, but with a significant degree of latitude in the methodology. The protocol allows for the use of internal models, provided the information is of the same type that the institution uses in the regular course of its business for valuing similar transactions.

This provision is a pragmatic recognition that sophisticated financial institutions build and maintain complex valuation systems as a core component of their risk management infrastructure. Forcing a party to disregard its own established, internally-consistent valuation methodology in favor of potentially scarce or unreliable external quotes could lead to a result that fails to reflect the true economic reality of the terminated trades.

However, this discretion is not absolute. The entire process is governed by two overriding principles ▴ the duty to act in “good faith” and the requirement to use “commercially reasonable procedures in order to produce a commercially reasonable result.” These principles form the guardrails that prevent the Determining Party from using its informational advantage to produce a self-serving or punitive valuation. The ability to use internal models is therefore conditional.

It is predicated on the idea that these models are part of a robust, consistent, and professionally managed valuation process that stands up to scrutiny. The question of exclusivity ▴ whether a party can rely only on its models ▴ is therefore less about permission and more about defensibility under these guiding principles.

Strategy

Valuation Methodologies a Comparative Framework

The strategic decision for a Determining Party revolves around selecting a valuation methodology that is not only accurate but also defensible. The ISDA framework permits a spectrum of approaches, primarily centered on external market data and internal modeling. Understanding the strategic trade-offs between these methods is fundamental to managing the close-out process effectively and minimizing the potential for costly disputes. A reliance on external quotes seems, on the surface, to be the most objective path.

Yet, for bespoke or illiquid transactions, obtaining multiple, firm quotes from reference market makers can be impractical or even impossible. This is where internal models provide a crucial alternative.

A strategic framework for valuation must weigh the characteristics of the terminated transactions against the available data sources. For highly liquid, vanilla interest rate swaps, for example, a valuation based on observable market data like yield curves and third-party quotes is likely the most commercially reasonable and defensible approach. Conversely, for a complex, long-dated structured product with limited secondary market activity, an internal model calibrated to observable inputs may be the only viable method for producing a rational valuation. The strategy is to create a procedural hierarchy where the most objective, external data is considered first, with reliance on internal models increasing as the transparency of the external market decreases.

The following table outlines the strategic considerations for each primary valuation methodology:

Navigating the Commercial Reasonableness Standard

The cornerstone of a defensible close-out calculation is the adherence to the standard of “commercial reasonableness.” This is not a precisely defined formula but a principle-based requirement that is assessed based on the prevailing circumstances. A strategy built around this standard involves creating a valuation process that is transparent, well-documented, and consistent with industry practices. The Determining Party must be able to demonstrate that its procedures were designed to produce a fair market value, not simply the most favorable outcome for itself.

A key strategic element is the concept of procedural diligence. This involves several concrete actions:

• Record Keeping ▴ Maintaining meticulous records of all information considered during the valuation process is essential. This includes any third-party quotes sought (even if unavailable), market data feeds used, and the specific parameters and assumptions of any internal models applied.
• Consistency ▴ The valuation methodology applied during the close-out should be consistent with how the Determining Party values similar transactions in the normal course of its business. A sudden, unexplained shift in valuation technique for a close-out can be a significant red flag in a dispute.
• Market Sounding ▴ Even when relying on an internal model, it is strategically wise to gather any available external data points as a cross-check or calibration source. Documenting that third-party data was considered, even if ultimately deemed unreliable, strengthens the argument that the process was reasonable.

Adherence to the commercial reasonableness standard requires a demonstrable process of diligent, good-faith efforts to ascertain a fair market valuation.

Ultimately, the strategy is one of pre-emptive defense. The Determining Party should conduct its valuation process as if it will eventually need to be explained and justified before a court or arbitration panel. This means that while internal models can be used, relying on them exclusively without first attempting to gather or consider external market indicators is a high-risk strategy. The ISDA framework requires the party to consider external quotes and data unless it reasonably believes they are unavailable or would not produce a reasonable result.

Documenting this belief is a critical step. The most robust strategy, therefore, is not one of exclusive reliance on internal models, but one where internal models are used as a primary tool within a broader, documented process that validates their output against the commercial realities of the market.

Execution

A Procedural Playbook for Model Based Valuation

Executing a defensible close-out valuation using internal models requires a systematic and meticulously documented process. The objective is to build a record that demonstrates adherence to the principles of good faith and commercial reasonableness at every stage. An institution acting as the Determining Party should establish a clear, internal operational playbook that is triggered by a counterparty default. This playbook ensures that the process is handled consistently and reduces the risk of procedural errors that could be challenged later.

The following steps outline a robust execution framework:

1. Official Declaration ▴ Formally declare the Early Termination Date in accordance with the ISDA Master Agreement. All subsequent valuation procedures will be anchored to this date.
2. Initial Market Scan ▴ Conduct and document a thorough scan for external valuation indicators as of the Early Termination Date. This includes actively seeking quotes for replacement transactions from third parties and gathering relevant market data (e.g. yield curves, volatility surfaces). The results of this scan, including failures to obtain quotes, must be logged.
3. Model Selection and Justification ▴ If the market scan indicates that reliable external data is unavailable or would produce an unreasonable result, the decision to use an internal model must be formally justified and documented. The selected model must be the same one used for valuing similar transactions in the regular course of business.
4. Input Parameter Calibration ▴ Calibrate the internal model using observable market data wherever possible. All inputs, such as interest rates, credit spreads, and funding costs, must be sourced from verifiable market data providers as of the Early Termination Date. The rationale for each input must be recorded.
5. Valuation Calculation ▴ Execute the model to calculate the replacement value of the terminated transactions. The output should represent the cost or gain of replacing the economic equivalent of the transaction portfolio.
6. Inclusion of Ancillary Costs ▴ When commercially reasonable and not duplicative, incorporate the costs or gains associated with terminating, liquidating, or re-establishing any hedges related to the terminated transactions. This requires a clear and documented link between the hedges and the terminated portfolio.
7. Internal Review and Approval ▴ The complete valuation, including all supporting documentation, should be reviewed and approved by an independent internal function, such as a market risk or model validation group, to ensure objectivity and procedural correctness.
8. Delivery of Calculation Statement ▴ Provide the counterparty with a statement detailing the Close-Out Amount. While the underlying model may be proprietary, the statement should provide sufficient detail to explain the basis of the calculation, including the key market data inputs used.

Quantitative Inputs and Model Transparency

The credibility of a valuation derived from an internal model is directly dependent on the transparency and integrity of its inputs. The Determining Party must be prepared to defend its choice of data and assumptions. The table below provides an example of the types of inputs required for valuing a standard interest rate swap and how they should be sourced and documented.

Predictive Scenario Analysis a Dispute over Valuation

Consider a scenario where a regional bank (“RB”) has a portfolio of 10-year interest rate swaps with a hedge fund (“HF”) that defaults. RB, as the Determining Party, calculates a Close-Out Amount of $15 million owed to it by HF. RB’s valuation is based on its internal pricing model, calibrated to market data on the Early Termination Date.

RB’s process involved an initial attempt to get quotes from three dealers, but two declined to quote on a portfolio of that size and duration, and the third provided a highly indicative quote that RB deemed commercially unreasonable. This entire process was documented.

HF’s liquidator challenges the calculation, arguing that RB’s exclusive reliance on its internal model was self-serving. They present an indicative valuation from a third-party service suggesting the amount should be closer to $12 million. The dispute hinges on whether RB’s procedures were commercially reasonable. RB’s defense rests on its meticulously documented execution playbook.

It provides evidence of its attempts to source external quotes and a clear justification for why the one received was unreliable. It furnishes a detailed report on its internal model, demonstrating that it is the same model used for all its regulatory and internal risk reporting and that it was calibrated using observable market curves from reputable data vendors.

A robust, documented, and consistent valuation process is the most effective defense against challenges to a Close-Out Amount calculated using internal models.

RB further provides the model inputs, as outlined in the table above, and explains how they were used to arrive at the $15 million figure. The key differentiator is the inclusion of a funding value adjustment (FVA) based on its documented cost of funding, which the third-party service used by HF did not include. RB argues that under the 2002 ISDA Master Agreement, including such costs is commercially reasonable and necessary to restore it to the economic equivalent of the original transaction.

Because RB’s process was systematic, consistent with its normal business practices, and thoroughly documented, a court or tribunal is highly likely to find that its actions were commercially reasonable, even though the final calculation was performed by an internal model. The transparency of the process and the defensibility of the inputs become the deciding factors.

Valuation as an Operational System

The question of utilizing internal models for a close-out valuation moves beyond a simple contractual permission slip. It compels an institution to examine the very core of its valuation infrastructure. Viewing this process not as a one-off legal event but as the execution of a critical operational system reveals its true strategic dimensions.

The integrity of the Close-Out Amount is a direct reflection of the integrity of the firm’s day-to-day risk and valuation processes. A calculation that is defensible under scrutiny is the output of a system that is robust, consistent, and transparent by design.

Therefore, the confidence with which a Determining Party can act in a crisis is forged long before any default occurs. It is built upon the daily discipline of model validation, consistent data sourcing, and meticulous record-keeping. The ISDA framework provides the protocols, but the quality of the execution depends entirely on the underlying operational architecture. The ultimate inquiry for any market participant is whether its internal systems are sufficiently robust to translate contractual rights into enforceable, commercially reasonable outcomes when it matters most.