What is a break clause on a swap and how is the breakage cost calculated?

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AcadiFi · Accepted Answer

A break clause (optional early termination, OET) lets one or both parties terminate the swap early on predetermined dates without cause. Breakage cost is paid by the exercising party if the swap has negative value to them, or received if positive.

Calculation: breakage = |MTM at break date| based on the agreed quotation method in the ISDA Schedule. Two common methods:

1. Market Quotation: poll 4 reference dealers for the replacement swap rate; discard high/low; average the middle two.

2. Close-out Amount (2002 ISDA): the non-exercising party determines a commercially reasonable estimate of the replacement cost using their own models.

Example: Kestrel Industries has a 10-year pay-fixed swap at 4.05% on $30M with a year-5 mutual break. At year 5, market 5-year fixed rate drops to 2.95%. Kestrel's swap is out-of-the-money by approximately (4.05% - 2.95%) × $30M × annuity(5yr) ≈ 0.011 × 30M × 4.62 ≈ $1.52M. To exercise the break, Kestrel pays the counterparty $1.52M plus potentially a $15-25K break fee.

Strategic use: corporates add break clauses to long-dated hedges when they want flexibility for M&A, divestitures, or debt refinancing. Pricing impact: break option has value — mid-market fixed rate on a swap with break is ~2-5bp higher than one without. Under IFRS 9, break options are embedded derivatives and generally not separated if the hybrid is also at FVTPL.

What is a break clause on a swap and how is the breakage cost calculated?

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