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 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 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 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, 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.