What Is Swap Termination and How Are Payments Calculated?

When an interest rate or currency swap ends before its scheduled maturity, the swap termination payment calculation collapses every outstanding transaction between the two parties into a single net figure. That figure has two parts: the current market value of replacing the terminated positions, and any amounts already owed but not yet paid. One side writes a check to the other, collateral is applied against the balance, and the contract is over. The mechanics are set by the ISDA Master Agreement, the standard contract behind virtually all over-the-counter derivatives worldwide.¹

The Two Components of the Final Payment

The ISDA Master Agreement calls the final settlement figure the Early Termination Amount. It is built from the Close-out Amount plus Unpaid Amounts.²

The Close-out Amount

The Close-out Amount represents the economic gain or loss the determining party would experience from replacing the terminated swap at current market prices. Put practically: what would it cost to walk into the market today and enter a new swap on the same terms as the one being terminated? If rates have moved against you since the original trade was executed, that replacement cost is what you owe.

In practice, this usually means soliciting quotes from third-party dealers to establish a replacement cost. When the market is too illiquid for reliable quotes, internal models and market data can be used instead, but the methodology must be defensible. The determining party has to act in good faith and use commercially reasonable procedures.

Unpaid Amounts

Unpaid Amounts capture everything already due before the Early Termination Date that had not been settled. If a quarterly payment on the swap was due last week and the counterparty never sent it, that amount does not disappear because the contract is now terminating. It gets folded into the final bill, along with any accrued interest or compensation on those overdue obligations.²

Combining the Two

For an Event of Default, 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 a single net number. If it is positive, the defaulting party pays. If it is negative, the non-defaulting party pays the absolute value to the defaulting party.² Even the party that caused the default can end up receiving money if the market has moved enough in its favor.

Who Runs the Calculation

The party responsible for producing the numbers is called the Determining Party, and its identity depends on why the swap terminated.

In an Event of Default scenario, the Determining Party is the non-defaulting side. In a Termination Event where only one party is affected, the non-affected party runs the numbers. When both parties are affected by the same Termination Event, each side independently calculates its own Close-out Amount, and the final figure splits the difference between the two valuations.²

How the Market Drives the Size and Direction of the Payment

The size of the termination payment is driven almost entirely by how far market rates have moved since the swap was originally executed. Consider a simple interest rate swap where you agreed to pay a fixed rate and receive a floating rate. If market rates have risen significantly since the swap started, your fixed-rate payment is now below the current market rate, making the swap valuable to you. You would receive a payment on termination. If rates have fallen, your fixed-rate payment is above the current market rate, and you would owe the termination payment.

The swap industry calls this difference “breakage”: the gap between the original swap rate and the current replacement rate. It is purely a function of where the market sits on the day of termination. A swap that was deeply in your favor last month could be against you today if rates moved sharply. That is why early termination payments can be substantial, and why parties rarely terminate voluntarily without a clear strategic reason to unwind the position.

How Posted Collateral Is Applied

Most swap counterparties post collateral under a Credit Support Annex, a companion document to the ISDA Master Agreement. When early termination occurs, that collateral does not sit in a separate bucket. The non-defaulting party can apply the value of collateral posted by the defaulting party against the net amount owed.³

If posted collateral exceeds the net obligation, the surplus must be returned to the defaulting party’s insolvency administrator. If the collateral falls short, the remaining balance becomes an unsecured claim in the bankruptcy proceeding, paid alongside other unsecured creditors as determined by the court.³ That residual unsecured claim is where real losses tend to concentrate. Recovering pennies on the dollar through bankruptcy is a common outcome when a major counterparty fails.

Timing of enforcement depends on the type of credit support document. Under a New York law variation margin annex, the secured party’s 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.⁴ Non-cash collateral such as government bonds or equities is typically subject to standardized haircuts when valued for close-out purposes, so a 10-year government bond might be valued several percentage points below face and equities in a major stock index can be haircut by 15% or more.

What Triggers Early Termination

The ISDA Master Agreement divides triggers into two categories, and the category determines who calculates the payment.

Events of Default

An Event of Default means one party failed to meet its obligations. The 2002 ISDA Master Agreement lists several categories, including failure to pay or deliver (after a one-business-day cure period following notice), breach of a material term (after 30 days’ notice) or outright repudiation, credit support default, misrepresentation, bankruptcy, and cross-default on other specified financial obligations above an agreed threshold.²

The non-defaulting party sends a notice designating an Early Termination Date for all outstanding transactions, up to 20 days out. For certain bankruptcy-related defaults, the agreement can be set to trigger Automatic Early Termination, meaning the contract terminates instantly without anyone sending a notice. That feature exists because a counterparty in bankruptcy proceedings may not be reachable or able to accept delivery.

Termination Events

Termination Events are no-fault triggers. Neither party did anything wrong, but circumstances have made the swap impossible or unreasonably expensive to maintain.

Illegality: A change in law makes it unlawful for one or both parties to perform.
Tax Event: A change in tax law forces additional tax-related payments that were not anticipated. The affected party must first try to transfer the swap to another office or affiliate where the tax problem does not exist before terminating.²
Force Majeure: An extraordinary event beyond either party’s control prevents performance. Force Majeure carries a mandatory eight-local-business-day waiting period during which payments are deferred rather than defaulted; only after that period expires without resolution can either party designate an Early Termination Date.²

For Illegality and Force Majeure, either party can terminate. For a Tax Event where only one side is affected, the affected party has the termination right, subject to the transfer attempt described above.

The Notice and Payment Timeline

Early termination begins with a formal written notice from the party exercising its right. The notice must identify the specific Event of Default or Termination Event and designate the Early Termination Date. A vague or procedurally defective notice can invalidate the entire termination attempt.

For an Event of Default, the notice can set an Early Termination Date up to 20 days from its effective date.² For Force Majeure and Illegality, the same 20-day window applies, but only after the eight-business-day waiting period has expired without a cure. The notice must be delivered through the exact channels specified in the agreement’s Schedule; wrong address or wrong method risks challenge.

Once the Early Termination Date arrives, the Determining Party calculates the Close-out Amount and delivers a detailed statement showing market inputs, methodology, and resulting figures. The ISDA Master Agreement does not impose a hard deadline for finishing the calculation, but the standard of commercial reasonableness means the Determining Party cannot drag its feet. Many counterparties negotiate a specific deadline in their Schedule, commonly five to ten business days.

Payment of the Early Termination Amount is due on the second or third business day after the statement is delivered, depending on what the parties agreed. Once that payment clears, all obligations related to the terminated transactions are extinguished. Neither side can come back later with additional claims on those positions.

Tax Treatment of the Payment

When a swap terminates early and one party receives a payment, that payment has tax consequences. 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 loss.⁵ For most corporate and institutional counterparties, the termination payment produces capital gain or capital loss, not ordinary income.

Capital treatment has practical implications. Capital losses can only offset capital gains, plus a limited amount of ordinary income for individual taxpayers. A large termination payment received increases capital gains for the year. A termination payment made produces a capital loss that may not fully offset your other income in the year it occurs.

An exception exists for dealers and traders who have made a mark-to-market election under Section 475(f) of the Internal Revenue Code. That election converts all gains and losses on covered securities, including interest rate and currency swaps, from capital treatment to ordinary income treatment. The fund or trading entity effectively marks its swap positions to fair market value at year-end regardless of whether termination occurs, and any termination payment is folded into ordinary income.

1
International Swaps and Derivatives Association. Legal Guidelines for Smart Derivatives Contracts: The ISDA Master Agreement
2
U.S. Securities and Exchange Commission. ISDA 2002 Master Agreement
3
International Swaps and Derivatives Association. ISDA Research Notes – The Importance of Close-Out Netting
4
International Swaps and Derivatives Association. ISDA Close-out Framework: Explanatory Notes
5
Office of the Law Revision Counsel. 26 U.S. Code 1234A – Gains or Losses from Certain Terminations