What is a Calculation Agent?
A calculation agent is a person or company that calculates how much the parties to certain derivatives owe each other.
How Does a Calculation Agent Work?
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 Does a Calculation Agent Matter?
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.