Bilateral Early Termination Rights in Total Return Swaps
Summary
The document discusses an optional early termination clause in a total return swap and asks whether it behaves like American exercise of a vanilla option. The clause described gives Party B a right to terminate a transaction on a business day with advance notice. The cash settlement is determined by a calculation agent under specified good-faith and market-practice standards, with payment due after the termination date. The practical question is whether a dealer would exercise the right when doing so appears beneficial and whether a contract without the clause can be ended early.
The answer says contractual documentation governs whether early termination is available. It argues that a bilateral termination option generally has no economic value at inception because each party is simultaneously long and short the right. Banks may still use such clauses to reduce xVA costs by limiting the theoretical exposure horizon. Actual exercise can depend on costs, reputation, and client relationships, with sales and risk teams potentially having competing preferences. The discussion offers practitioner reasoning rather than data on exercise frequency or a detailed pricing analysis.
Key ideas
- Early termination depends on the rights granted by the transaction documentation.
- The described clause permits termination with advance notice and a market-based cash settlement.
- A bilateral termination right is described as having no initial economic value because the parties hold offsetting positions.
- Banks may use early termination clauses to limit exposure horizons and reduce xVA costs.
- Exercise decisions can reflect costs, reputation, and commercial relationships.
Tags
Full text
# 'Optional Early Termination' clause # 'Optional Early Termination' clause For market practitioners such as swap traders out there: in your experience, does the below clause when bilateral is similar to a difference between `European` and `American` exercise on a vanilla option? Asking in the context of a TRS contract (either equity or fixed income). In other words, does it the presence of such clause would truly entice the dealer trade out of the contract if deemed profitable similar to `American` exercise? On the other hand, would the absence of it truly make the TRS "unbreakable"? It is understandable that the value of unilateral > bilateral > no clause. The question is how often if at all have you seen the bilateral clause being exercised by a dealer? Optional Early Termination Optional Early Termination. Notwithstanding anything to the contrary in the Definitions or the Agreement, the parties hereby agree to the following Optional Early Termination provisions: Party B shall have the right (but not the obligation) to terminate any Transaction hereunder, in whole or in part, effective as of any Business Day (the “Optional Early Termination Date”), by providing Party A with notice of its exercise of this right one Business Days prior to the Optional Early Termination Date. This notice shall be irrevocable and may be given orally, including by telephone. Such notice shall be followed by a written confirmation confirming the substance of any telephonic notice before the close of business on the Business Day that telephonic notice is provided. Such Transaction shall be terminated in accordance with Section 6(e)(ii)(1) (without the occurrence of a Termination Event or an Event of Default) such that the amount payable (the “Cash Settlement Amount”) will be determined by the Calculation Agent as if the party electing to terminate such Transaction were the sole Affected Party. The Calculation Agent shall determine such Cash Settlement Amount in good faith and in a commercially reasonable manner in accordance with normal market practice in the relevant market, taking into account market conditions at such time. Party B acknowledges and agrees that market value used to calculate such Cash Settlement Amount may not correspond with closing prices of a commodity index or the futures components of a commodity index, particularly during a period of disrupted market conditions. Such determination shall be made on the Optional Early Termination Date. Party A or Party B (as determined by the Calculation Agent) shall pay to the other party the Cash Settlement Amount on the second Business Day following the Optional Early Termination Date. Once the Cash Settlement Amount has been fully and finally paid, then all rights, duties and obligations of the parties under and with respect to such Transaction, or part of such Transaction, as applicable, shall terminate. ## Answer by David Duarte (score 2) https://quant.stackexchange.com/a/60555 I would agree with the comment about not being able to early terminate if the documentation doesn't support it. In terms of pricing, bilateral early terminations in general have no economic value because whatever the value of the option, both parties are long and short the option at the same time. These options are usefull for banks to reduce xVA costs, since they limit the theoretical horizon of the exposure, without changing the initial price. The reasons why dealers may or may not exercise the early termination can be many (costs, reputation commercial relation,...), and there will probably be a "fight" between the sales guys that don't want to tell the client that his position is being called and the risk guys that want to terminate the exposure.
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