Agreement Value Method

In derivative trading, there is a kind of contract known as a "swap." Here's an oversimplified definition: these deals involve people (well, usually they involve financial institutions, but banks are people too, right?) trading something that they eventually plan on trading back. Essentially, they are trading use of a thing, but not the thing itself.

Think of it like mutual borrowing. Saying to a friend "hey, let me borrow your car today and I'll let you watch a movie on my high-tech home theater system." This is a swap. You and your friend get use of each other's stuff for limited period of time.

Don't feel bad if that all hasn't sunk in. The derivatives market itself can get somewhat confusing, and swaps possibly represent the most confusing part. But for defining this term, the key for a swap is that there is a time limit. An expiration.

But sometimes these swaps get ended earlier than expected. Say something comes up that interrupts operation of one of the items in a swap, like a bankruptcy or a merger. Because of the early termination, one side owes the other side something as compensation.

In the example we discussed, you borrowed your friend's car, as you guys agreed, but while driving around you get a call: "hey, the power went out. I can't watch the movie." You got to use the car, but your friend didn't get their movie. You need to come up with something else to give them.

The Agreement Value Method is one of the ways to figure out what's owed when a swap ends early. (And an obviously dangerous one, because when two parties just agree on some value of an esoteric property, there is a kind of confusion-liability embedded in that agreement, as it's likely that, down the line, somebody will feel screwed.) Specifically, the International Swaps and Derivatives Association has three approved methods for figuring out termination payments when a swap ends prematurely. The Agreement Value Method is the most common one. (The others, by the way, consist of the Indemnification Method and the Formula Method, but we won't go into those here.)