An issuer can't always guard against termination of a swap before final maturity, but limited two-way payments and other special terms and can make the situation less of a headache.

At any time, the fixed-rate side of the transaction may be above or below the current market rate for swaps. The market value of the swap is based on the difference between the current rate and the rate on the swap. The higher the rate on the swap is above current rates, the more valuable the swap is to the side receiving the fixed-rate payment. If the rate is below current rates, the swap is valuable to the side receiving the floating-rate payments.

If the swap terminates early, the party on the unprofitable side must compensate the counter-party for the loss of the expected payments.

A swap can terminate if one party defaults or is downgraded below a certain level. So an issuer could find its swap terminated early because its counterparty defaulted.

If the issuer was on the profitable side, it would face the loss of those above-market payments. If the swap was being used in combination with a variable-rate bond offering, the issuer might unexpectedly face higher debt service as well.

But the credit losses can be mitigated by collateral provisions. If the counterparty defaults, the issuer can seize the collateral and use it to buy a new swap.

A very different problem can arise if, on a net basis, the issuer was making above-market payments to the counterparty.

The counterparty's default would still trigger an early termination, but the issuer wouldn't be losing much. However, the early termination would obligate the issuer to make a termination payment to the defaulting counterparty.

The termination payment may be millions of dollars and sometimes must be paid very soon after the swap terminates. That can create a cash crunch for an issuer without liquid assets on hand.

To help issuers avoid the problem, some swaps include a very different set of terms relating to early termination known as limited two-way payments.

Under limited payments, the issuer is freed of the obligation to make a termination payment if the termination was caused by the counterparty's defaulting.

The master swap agreement promulgated by the International Swaps and Derivatives Association includes both options. Full two-way payments will apply unless the parties indicate that they would prefer limited two-way payments.

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