What Is Swap Termination and How Are Payments Calculated?

When an ISDA-governed swap ends before its scheduled maturity, the swap termination payment is calculated by collapsing every outstanding transaction between the two parties into a single net figure. That figure has two building blocks: a Close-out Amount that reflects what it would cost to replace the terminated positions at current market prices, and Unpaid Amounts covering anything already owed but not yet settled. Whichever side ends up net positive receives the payment; the other side pays it. The direction does not depend on who caused the termination, only on where the market sits on the day the contract ends.¹

The Two Components of the Final Payment

The full settlement figure under the 2002 ISDA Master Agreement is called the Early Termination Amount. It is the sum of two pieces.

The Close-out Amount captures the current market value of the terminated positions. In plain terms, it answers a single question: what would it cost the determining party to walk into the market today and put on a new swap with identical terms to the one being closed out? If rates have moved against that party since the original trade, replacement is expensive, and the Close-out Amount reflects that loss. If rates have moved in its favor, replacement is cheap, and the Close-out Amount reflects a gain.

Unpaid Amounts cover obligations that came due before the Early Termination Date but were never settled. A quarterly payment that was owed last week does not disappear because the contract is now ending. It rolls into the final bill, together with any accrued interest or compensation on the overdue amount.¹

How the Netting Works

For an Event of Default, the arithmetic is straightforward. The non-defaulting party adds up the Close-out Amount for each terminated transaction and the Unpaid Amounts owed to it, then subtracts any Unpaid Amounts it owes to the defaulting party. The result is one net number. If positive, the defaulting party pays. If negative, the non-defaulting party pays the absolute value to the defaulting party.¹

That second outcome surprises people. Even the party that caused the default can end up receiving money if the market has moved far enough in its favor. The calculation is about market value, not fault.

Close-out netting is what makes this possible. Without it, the non-defaulting party might owe gross amounts on some transactions while trying to collect gross amounts on others, running enormous credit exposure at exactly the moment its counterparty is failing.² Netting collapses the whole portfolio to one number so that credit risk is measured, and paid, on a net basis.

Who Runs the Calculation

The party responsible for producing the Close-out Amount is called the Determining Party, and which side plays that role depends on why the swap is terminating.

In an Event of Default (missed payment, breach, misrepresentation, bankruptcy, cross-default, credit support failure), the non-defaulting party calculates. In a Termination Event affecting only one side, such as a Tax Event that hits one counterparty, the non-affected party calculates. When both parties are affected, as can happen with Illegality or Force Majeure, each side independently runs its own Close-out Amount and the final figure splits the difference between the two valuations.¹

The Standard for the Calculation

The Determining Party must act in good faith and use commercially reasonable procedures. In liquid markets that usually means soliciting firm quotes from third-party dealers for a replacement swap and using those quotes to price the close-out. When the market is too thin or too stressed for reliable quotes, internal models and observable market data can be used instead, but the methodology has to be defensible if challenged later.

The agreement does not set a hard deadline for producing the calculation, but the commercial reasonableness standard means the Determining Party cannot delay indefinitely. Many counterparties negotiate a specific window in their Schedule, commonly five to ten business days after the Early Termination Date.

Why Market Movement Drives the Size

The termination payment can be small, large, or enormous, and the difference is almost entirely a function of how far rates have moved since the swap was executed.

Take a plain interest rate swap where you agreed to pay a fixed rate and receive a floating rate. If market rates have risen sharply since the trade, your fixed payment is now below the current market rate. The swap is valuable to you, and you would receive a payment on termination. If rates have fallen instead, your fixed payment is above the current market rate, the swap is a liability, and you would owe the payment.

The industry calls this gap “breakage”: the difference between the original swap rate and the current replacement rate. Breakage is purely a snapshot of where the market sits on the day of termination. A position that was deeply favorable last month can flip against you today if rates move. That volatility is why parties rarely terminate voluntarily without a clear strategic reason, and why the number produced on the Early Termination Date can look very different from anything either side expected when the trade was booked.

How Posted Collateral Is Applied

Most active swap counterparties post collateral under a Credit Support Annex, and that collateral feeds directly into the termination settlement. It does not sit in a separate pool. The non-defaulting party can apply the value of collateral posted by the defaulting party against the net amount owed.²

If the collateral exceeds the net obligation, the surplus goes back to the defaulting party (or its insolvency administrator, if bankruptcy is involved). If the collateral falls short, the remaining balance becomes an unsecured claim in the bankruptcy proceeding, paid alongside other unsecured creditors at whatever recovery rate the court determines.² That residual claim is where real losses concentrate when a major counterparty fails.

Non-cash collateral is subject to standardized haircuts when it is valued for close-out. A 10-year government bond might be valued at 4% to 6% below face; equities in a major stock index can be haircut by 15% or more. Those discounts protect the secured party from a drop in collateral value during the liquidation window.

Timing of collateral enforcement varies with the document. Under a New York law variation margin annex, the right to liquidate collateral is triggered as soon as the Event of Default occurs, even before an Early Termination Date is formally designated. Under English law documents and initial margin annexes, those rights only kick in once the Early Termination Date has been set.³

What Has to Happen Before the Number Is Calculated

The termination payment only comes into being once early termination is properly triggered. The ISDA Master Agreement recognizes two broad triggers: Events of Default, which are one side’s failures, and Termination Events, which are no-fault circumstances that make the swap unworkable.

Events of Default include failure to pay or deliver (with a one-business-day cure after notice), breach or repudiation, credit support default, misrepresentation, bankruptcy, and cross-default on other financial obligations above a specified threshold.¹ For bankruptcy-related defaults, the agreement can be set to trigger Automatic Early Termination so that the contract ends instantly, without notice, at the moment insolvency begins. This exists because a counterparty inside bankruptcy proceedings may not be able to receive a termination notice at all.

Termination Events include Illegality, Tax Event, and Force Majeure. A Tax Event requires the affected party to first try to move the swap to another office or affiliate where the tax problem does not exist before it can terminate. Force Majeure carries a mandatory eight-local-business-day waiting period during which payments are deferred rather than defaulted; only if the situation is unresolved after that window can either side designate an Early Termination Date.¹

The Notice and Payment Timeline

Termination begins with a formal written notice identifying the specific trigger and designating the Early Termination Date. That date can be up to 20 days from the effective date of the notice.¹ The notice must go through the exact channels specified in the Schedule; a defective notice can invalidate the whole termination attempt.

Once the Early Termination Date arrives, the Determining Party runs the calculation and delivers a statement showing the market inputs, methodology, and resulting figures. Payment of the Early Termination Amount is due on the second or third business day after that statement is delivered, depending on the parties’ agreed terms. Once payment clears, obligations on the terminated transactions are extinguished. Neither side can revive claims on those positions later.

Tax Treatment of the Payment

The termination payment has tax consequences on both sides. Under federal tax law, gain or loss from the termination of a right or obligation connected to a capital asset is treated as capital gain or capital loss.⁴ For most corporate and institutional counterparties, that means the payment produces capital gain or loss rather than ordinary income.

The distinction has real consequences. Capital losses can offset capital gains and, for individual taxpayers, a limited amount of ordinary income. A large termination payment received increases capital gains for the year; a large one paid produces a capital loss that may not fully offset other income in that year.

An exception applies to dealers and traders who have made a mark-to-market election under Section 475(f) of the Internal Revenue Code. That election converts gains and losses on covered securities, including interest rate and currency swaps, from capital to ordinary treatment. Under the election, positions are marked to fair market value at year-end regardless of whether termination occurs, and any termination payment folds into ordinary income.

1
U.S. Securities and Exchange Commission. ISDA 2002 Master Agreement
2
International Swaps and Derivatives Association. ISDA Research Notes – The Importance of Close-Out Netting
3
International Swaps and Derivatives Association. ISDA Close-out Framework: Explanatory Notes
4
Office of the Law Revision Counsel. 26 U.S. Code 1234A – Gains or Losses from Certain Terminations