How Mandatory Breaks Affect Interest Rate Swap Valuation

Summary

The note explains that a mandatory break in an interest rate swap generally does not change the swap’s ordinary valuation or hedge. It can, however, reduce counterparty valuation adjustment and funding valuation adjustment charges because the contract is assured to remain in place only until the break date. The discussion focuses on the break’s effect on counterparty costs, rather than the swap’s market risk valuation.

It also describes a market-based termination before the contractual break as a way to avoid uncertainty over the legal termination procedure. If the parties roll the swap, they can terminate the existing contract and enter a replacement with a new break date. A caveat is that “Bermudan” may mean the contract contains strike-based exercise optionality; that is a separate feature requiring different pricing from a plain swap. The note gives qualitative guidance but no valuation formula or quantitative example.

Key ideas

• A mandatory break can lower CVA and FVA because it limits how long the swap is guaranteed to remain outstanding.
• The swap is otherwise valued and hedged as a standard interest rate swap.
• Parties may terminate through a market method before the break to reduce uncertainty about legal termination procedures.
• Strike-based Bermudan optionality is a separate pricing feature from a mandatory break.

Tags

# IRS with early termination provision


# IRS with early termination provision












I have an IRS with an early termination clause (Bermuda style). Do I value it as always or does it have any impact on the value?

## Answer by Attack68 (score 2)

https://quant.stackexchange.com/a/80048

Mandatory breaks are quite common on IRS. They are primarily used by corporations without CSAs' to allow that counterparty to gain access to long dated swaps facing banks without high XVA add-on charges. The reason being that the swap is guaranteed to exist only for a certain amount of time hence it typically lowers the calculation of CVA/FVA charges.

From the IRS perspective they are valued as normal, and hedged as normal. Usually a note is placed on these swap to use a market method of termination ahead of the mandatory break so as to not rely on the legal method of termination method specified in the legal docs, which can cause uncertainty for both counterparties.

If the swap is to be rolled this is usually the cheapest methods, becuase it involves terminating the old swap and replacing with a new swap with some new mandatory break clause.

### EDIT

If by Bermudan, you mean that the swaps have some embedded optionality (relative to a strike) associated with them then that optionality is a completely different aspect of pricing and these swaps will not be priced the same as a normal swap without the optionality.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.