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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Calculation Agent

What it is:

A calculation agent is a person or company that calculates how much the parties to certain derivatives owe each other.

How it works (Example):

For example, consider an interest rate swap, which is a contractual agreement between two parties to exchange interest payments. Let's assume that Charlie owns a $1 million investment that pays him LIBOR + 1% every month. As LIBOR goes up and down, the payment Charlie receives changes. Now assume that Sandy owns a $1 million investment that pays her 1.5% every month. The payment she receives never changes.

Charlie decides that that he would rather lock in a constant payment and Sandy decides that she'd rather take a chance on receiving higher payments. So Charlie and Sandy agree to enter into an interest rate swap contract.

Under the terms of their contract, Charlie agrees to pay Sandy LIBOR + 1% per month on a $1 million principal amount (called the "notional principal" or "notional amount"). Sandy agrees to pay Charlie 1.5% per month on the $1 million notional amount.

Let's say Charlie receives a monthly payment of $12,500 from his investment ($1,000,000 x (0.25% + 1%)). Sandy receives a monthly payment of $15,000 from her investment ($1,000,000 x 1.5%).

Now, under the terms of the swap agreement, Charlie owes Sandy $12,500 ($1,000,000 x LIBOR+1%) , and she owes him $15,000 ($1,000,000 x 1.5%). The two transactions partially offset each other and Sandy owes Charlie the difference: $2,500. The calculation agent keeps tabs on the swap, makes the calculation that Sandy owes Charlie $2,500, and ensures the payment is made.

Why it Matters:

For many derivatives, on the payment date, the parties only exchange the profits or losses, as our example shows. The calculation helps with this, but also acts as a mediator and can make binding decisions on disputes between the parties. The calculation agent also provides the parties with alternatives for settling their accounts.

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