How Does the Close-Out Amount Calculation Differ between a Force Majeure Event and a Standard Event of Default?

Concept

The calculation of a close-out amount under an ISDA Master Agreement represents the conversion of future contractual obligations into a single, present-day monetary value. This mechanism is the financial core of contract termination, crystallizing the economic exposure between two counterparties when their derivatives portfolio is prematurely unwound. The distinction in how this value is calculated, when triggered by a standard Event of Default versus a Force Majeure Event, is a foundational element of the market’s risk architecture. It reflects a deliberate and systemic choice to treat a counterparty’s failure differently from a market-wide paralysis.

An Event of Default is an endogenous failure. It is a breach of contract, a failure of one of the parties to perform its obligations as defined within the agreement. The resulting close-out calculation is therefore designed as a protective mechanism for the non-breaching party.

The process grants the Non-Defaulting Party significant control and discretion, empowering it to preserve the economic equivalent of its bargain. The operational calculus is rooted in assigning fault and providing a remedy that makes the innocent party whole.

The core distinction lies in the allocation of control over the valuation process, which shifts from unilateral in an Event of Default to bilateral in a Force Majeure scenario.

A Force Majeure Event, conversely, is an exogenous shock. It is an external event, beyond the control of either party, that renders performance impossible or impracticable. Under the 2002 ISDA Master Agreement, this triggers a process built on the principle of shared misfortune. There is no defaulting party, only two affected parties.

The close-out calculation, therefore, pivots from a unilateral, protective action to a bilateral, equitable settlement. The objective is to find a fair, mid-market valuation that does not unduly penalize or reward either counterparty for a situation that neither caused. This structural difference in the calculation protocol is a critical component of systemic risk management, ensuring that market-disrupting events are handled with a framework designed for mutual resolution rather than punitive action.

Strategy

The strategic considerations underpinning the close-out calculation diverge significantly between an Event of Default and a Force Majeure Event. The choice of strategy is dictated by the nature of the termination and the role assigned to each party by the ISDA framework. The entire process shifts from a defensive, unilateral action to a collaborative, bilateral procedure.

Event of Default a Unilateral Valuation Strategy

In the context of an Event of Default, the strategy is inherently one-sided. The Non-Defaulting Party is vested with the authority to act as the sole “Determining Party.” This grants it control over the valuation process, a critical strategic advantage. The overarching goal is to calculate an Early Termination Amount that fully compensates the Non-Defaulting Party for the economic loss of its bargain, as if the Defaulting Party had fulfilled all its obligations.

The Determining Party’s strategic flexibility is embedded in the methodology it can employ:

• Close-Out Amount (2002 ISDA) This is the modern, flexible standard. The Determining Party must use commercially reasonable procedures to produce a commercially reasonable result. This allows for the use of internal models, third-party quotations, and relevant market data, providing the Determining Party with a broad toolkit to arrive at a valuation that protects its economic interests.
• Loss (1992 ISDA) A broader and more subjective measure, allowing the Determining Party to calculate its total losses and costs in connection with terminating the agreement, including the loss of its economic bargain.
• Market Quotation (1992 ISDA) A more structured approach requiring the Determining Party to obtain quotes from leading market makers for replacement transactions. This method is more objective but can be less flexible in volatile or illiquid markets.

The strategy for the Non-Defaulting Party is to use its discretion to achieve the most favorable and defensible valuation, effectively preserving its economic position at the expense of the party that failed to perform.

Force Majeure a Bilateral Equitable Strategy

Upon the occurrence of a Force Majeure Event, the strategic framework undergoes a fundamental transformation. Under the 2002 ISDA, both counterparties are designated as “Affected Parties.” Consequently, there is no single Determining Party. Instead, the process becomes bilateral, with each party independently calculating a Close-out Amount for the terminated transactions.

The strategic objective here is fairness and the achievement of a mid-market valuation. The ISDA architecture is designed to prevent either party from exploiting the situation. The methodology is prescribed to be equitable:

• Bilateral Calculation Each party determines its own Close-out Amount for the portfolio.
• Mid-Market Aim The final Early Termination Amount is derived from the average of the two independently calculated figures. This neutralizes bias and steers the final value toward a consensus, mid-market price.
• Creditworthiness Exclusion When seeking third-party quotes for this purpose, the parties are explicitly instructed to disregard the current creditworthiness of the counterparty, preventing the distress of the situation from devaluing the claims.

In a Force Majeure termination, the calculation methodology is engineered to produce a fair, mid-market valuation by averaging the inputs from both affected parties.

A critical strategic element is the “Hierarchy of Events.” The ISDA Master Agreement specifies that if a set of circumstances constitutes both a Force Majeure Event and an Event of Default (for example, a government action that triggers an Illegality but also causes a failure to pay), it will be treated as an Event of Default. This makes the correct and timely classification of the event a paramount strategic decision, as it dictates which valuation regime will apply.

How Do Valuation Strategies Compare?

The strategic differences are stark and can be summarized in the following table.

Execution

The execution of the close-out calculation is a precise, multi-step process governed by the ISDA Master Agreement. The operational workflow, from the initial notice to the final settlement payment, is entirely different for an Event of Default compared to a Force Majeure Event, reflecting their distinct underlying principles.

Executing the Calculation for an Event of Default

The process is linear and driven by the Non-Defaulting Party. It is an exercise in control and remedy.

1. Notice of Early Termination Upon the occurrence of an Event of Default, the Non-Defaulting Party has the right to designate an Early Termination Date by giving notice to the Defaulting Party. This notice crystallizes the termination of all outstanding transactions under the agreement.
2. Unilateral Calculation of Close-out Amount The Non-Defaulting Party, as the sole Determining Party, calculates the Close-out Amount. Per the 2002 ISDA, this requires acting in good faith and using “commercially reasonable procedures in order to produce a commercially reasonable result.” This may involve:
   • Obtaining quotations from third-party dealers for replacement trades.
   • Using internal, proprietary models to price the terminated transactions.
   • Consulting relevant market data, such as observable prices, yield curves, and volatility surfaces.
3. Aggregation and Netting The Determining Party aggregates all the calculated Close-out Amounts (which can be positive or negative) for every terminated transaction. This sum is then combined with any Unpaid Amounts (payments or deliveries that were due but not made prior to termination). The result is a single net figure known as the Early Termination Amount.
4. Final Settlement If the Early Termination Amount is positive, it is payable by the Defaulting Party to the Non-Defaulting Party. If it is negative, under the “Second Method” and the 2002 ISDA standard, the Non-Defaulting Party pays that amount to the Defaulting Party, ensuring a full two-way payment.

Executing the Calculation for a Force Majeure Event

The execution for a Force Majeure Event is a more patient, collaborative, and structured process designed for an equitable outcome.

1. Waiting Period The process begins with a “waiting period” after the Force Majeure Event occurs. For Force Majeure, this is typically eight Local Business Days. During this time, payment and delivery obligations affected by the event are deferred. This period allows time for the disruption to potentially resolve itself.
2. Designation of Early Termination Date If the Force Majeure Event is still continuing after the waiting period has expired, either of the Affected Parties may designate an Early Termination Date for the affected transactions.
3. Bilateral Calculation of Close-out Amount This is the crucial distinction. Both parties independently calculate a Close-out Amount for the terminated transactions. Each must act in good faith and use commercially reasonable procedures, with the goal of determining a fair market value.
4. Determination of the Early Termination Amount The two separately calculated Close-out Amounts are not used to make competing claims. Instead, they are inputs into a specific formula defined in the 2002 ISDA Master Agreement. The Early Termination Amount is calculated as the sum of:
   • One-half of the difference between the higher amount (determined by party X) and the lower amount (determined by party Y).
   • The Unpaid Amounts owing to party X.
   • Less the Unpaid Amounts owing to party Y.

   This formula effectively averages the two valuations to arrive at a single, equitable settlement amount.

5. Settlement The final calculated Early Termination Amount is paid by one party to the other. The process ensures that neither party is able to unilaterally impose a valuation on the other.

What Is the Quantitative Impact of These Differences?

A hypothetical scenario can illustrate the practical impact of these divergent execution paths. Consider a portfolio of interest rate swaps between Party A and Party B.

In this simplified example, the unilateral discretion afforded to Party A in the Event of Default scenario results in a higher valuation in its favor. The bilateral, averaging mechanism required by the Force Majeure event produces a more moderate, mid-market outcome. This quantitative difference is a direct result of the distinct execution protocols mandated by the ISDA architecture.

Reflection

Calibrating the Response Mechanism

The procedural divergence in close-out calculations is a masterclass in risk system design. It is a pre-negotiated, codified acknowledgment that the nature of a crisis dictates the appropriate response. An internal failure of a counterparty requires a swift, decisive, and protective remedy. A systemic, external shock demands a process that preserves the integrity of the market itself by preventing fire sales and opportunistic valuations.

Understanding this distinction is fundamental to appreciating the resilience of the derivatives market architecture. It prompts a critical question for any market participant ▴ is your own operational framework calibrated to respond with the same level of precision to different types of systemic stress?