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FRM Exam Part II · Netting, Close-out and Related Aspects

Close-out Amount and Valuation at Default Explained

Updated 11 October 2026

The close-out amount is the single sum the non-defaulting party calculates after an early termination, by valuing the terminated trades at the time of default. Under ISDA 2002 it uses commercially reasonable procedures and may rely on quotes or internal models. The net figure is the sum of trade values plus unpaid amounts, less any collateral held.

Understand Close-out Amount and Valuation at Default

When a counterparty defaults, the non-defaulting party can terminate all trades under the ISDA Master Agreement. Close-out netting then collapses every trade into one net number. The close-out amount is how that number is valued. It answers: what would it cost the survivor to replace the lost trades, or what value did it lose?

The ISDA 1992 form offers two measures: Market Quotation and Loss. Market Quotation uses quotes from several reference market-makers (usually four). With three or more quotes, the highest and lowest are discarded (if more than one quote shares the highest or lowest value, only one is discarded) and the arithmetic mean of the rest is used. With three quotes this gives the middle one. With two quotes, the arithmetic mean of both is used. Fewer than three quotes does not by itself defeat Market Quotation. It fails only if no quote can be obtained, or if the result would not be commercially reasonable. Then Loss is used instead. Market Quotation can therefore fail in a crisis when quotes are unavailable. Loss is a good-faith estimate of the survivor's loss. Parties pick one in the Schedule. The ISDA 2002 form replaces both with a single Close-out Amount. The survivor determines it acting in good faith and using commercially reasonable procedures to produce a commercially reasonable result.

Under the 2002 form the determining party may take into account relevant information, including quotations from dealers, market data and internal models, provided the inputs are market-based where available. It may include the cost of terminating, liquidating or re-establishing hedges and related trading positions. The Close-out Amount may also reflect the economic value of the terminated transactions. The amounts should be determined as of the early termination date, or as soon after as is commercially reasonable. Where the survivor cannot reasonably do this on that date, the 2002 form lets it value at a later time, for example if markets are closed or disrupted.

From a risk view, the gap between default and valuation matters. Prices keep moving while the survivor unwinds and hedges. This is the close-out period, closely linked to the margin period of risk used for collateralised exposure. A longer period means more exposure that variation margin may not cover. Valuation risk also comes from illiquid trades, wide bid-offer spreads and model choice.

Disputes arise because the survivor sets the number and the defaulter's estate wants it low. Challenges usually target the procedures used, the choice of inputs and any claimed hedge costs. Documentation of the process is the survivor's best defence.

Key formulas to remember

Net amount payable at early termination
Net amount = Σ (close-out values of terminated trades) + unpaid amounts owed to the survivor − unpaid amounts owed by the survivor
Positive means the defaulter owes the survivor. Negative means the survivor owes the defaulter's estate, subject to the Schedule and the form used. Under the 2002 form, unpaid amounts are not part of the Close-out Amount. They are added separately to reach the Early Termination Amount.
Net amount after collateral
Residual net claim = Net amount payable − collateral held by the survivor
Collateral held is applied against the amount owed, and what is left is the residual net claim. If collateral exceeds the amount, the surplus is returned to the defaulter's estate.
Market Quotation (ISDA 1992)
With three or more quotes: value = arithmetic mean of the quotes left after discarding the highest and the lowest (if several share the highest or lowest value, discard only one). Three quotes give the middle quote. Four quotes give the average of the two middle ones. With two quotes: value = their arithmetic mean.
Fewer than three quotes does not by itself trigger Loss. If no quotation can be obtained, or the result would not be commercially reasonable, Loss is used instead.
ISDA 2002 standard
Close-out Amount = good-faith, commercially reasonable determination of the survivor's total losses or gains
Uses quotes, market data or internal models. Includes hedge unwind costs. One method replaces both 1992 measures.
Exposure growth over close-out period
Potential price move at confidence level c ≈ z_c × σ × √(MPOR) × position value (σ as annual volatility, MPOR in years)
Rule of thumb for a single position under normal returns, where z_c is the standard normal multiplier (about 1.645 for 95% one-sided). Longer close-out periods raise uncollateralised exposure.

How to solve Close-out Amount and Valuation at Default questions

Use this order for any question on close-out valuation at default.

  1. 1Identify the form: ISDA 1992 (Market Quotation or Loss) or ISDA 2002 (Close-out Amount).
  2. 2Fix the early termination date and the valuation date. Note any delay allowed.
  3. 3List each terminated trade and decide its value to the survivor: positive if in the money to the survivor, negative if out of the money.
  4. 4Add or subtract unpaid amounts due before termination.
  5. 5Apply the valuation rule: under Market Quotation, drop the highest and lowest quote and average the rest, or use the mean if there are two quotes. Under Loss or 2002, use a good-faith commercially reasonable figure.
  6. 6Net all values into one amount, then subtract collateral held.
  7. 7Interpret: who pays whom, the residual claim after collateral and any residual exposure from the close-out period or disputes.

Quickest way: Sum, net, subtract collateral

When to use it: For numerical multiple-choice items that give trade values and ask for the final claim.

  1. Check the sign of each trade from the survivor's side.
  2. Add all trade values and unpaid amounts to get one net number.
  3. Subtract collateral held.
  4. For quotation questions, drop the highest and lowest and average the rest.
  5. Match the result to one option and check the sign.

Common mistakes in Close-out Amount and Valuation at Default

  • Treating Market Quotation and Close-out Amount as the same method.

    Both produce a replacement value, so they look alike.

    Fix: Remember Market Quotation is a fixed quote-averaging procedure. The 2002 Close-out Amount is a flexible, commercially reasonable determination that can use models.

  • Averaging all quotes instead of discarding the highest and lowest.

    Students recall a simple average.

    Fix: Under 1992 Market Quotation with four quotes, drop the highest and lowest and average the remaining two.

  • Netting without including unpaid amounts or collateral.

    The question focuses on trade values.

    Fix: Always add unpaid amounts and subtract collateral held before stating the claim.

  • Getting the sign wrong when some trades favour the defaulter.

    Values are read from the wrong party's view.

    Fix: Take the survivor's view. Trades where it owes money are negative and reduce the net amount.

  • Ignoring the close-out period and valuation timing.

    The calculation seems static.

    Fix: State that prices move between default and unwind. This gap drives the margin period of risk and the case for allowing later valuation in disrupted markets.

  • Thinking the survivor's figure cannot be challenged.

    The survivor makes the determination.

    Fix: Remember the standard is good faith and commercially reasonable procedures. Weak documentation or biased inputs invite disputes.

Worked examples

Example 1

Under ISDA 1992 Market Quotation, a survivor obtains four quotes to replace a terminated trade: USD 2.0 million, USD 2.4 million, USD 2.6 million and USD 3.2 million. What is the Market Quotation value?

Show the solution
  1. Order the quotes: 2.0, 2.4, 2.6, 3.2.
  2. Discard the highest (3.2) and the lowest (2.0).
  3. Average the remaining two: (2.4 + 2.6) ÷ 2 = 2.5.

Answer: USD 2.5 million

Example 2

After a default, a survivor terminates three trades under the ISDA 2002 form. Close-out values from its view: Trade A +USD 6.0 million, Trade B −USD 2.5 million, Trade C +USD 1.5 million. An unpaid amount of USD 0.5 million is owed to the survivor. It holds USD 3.0 million of collateral. What is the residual net claim on the defaulter?

Show the solution
  1. Sum trade values: 6.0 − 2.5 + 1.5 = 5.0.
  2. Add the unpaid amount owed to the survivor, which the 2002 form treats separately from the Close-out Amount: 5.0 + 0.5 = 5.5.
  3. Apply the collateral held against this amount: 5.5 − 3.0 = 2.5.

Answer: After applying collateral, the residual net claim on the defaulter is USD 2.5 million

Exam tips

  • Know the 1992 versus 2002 contrast cold: two measures versus one flexible Close-out Amount.
  • In numerical items, finish with the collateral step. Many wrong options leave it out.
  • Link close-out period to margin period of risk when a question mentions exposure after default.
  • Watch for words like good faith and commercially reasonable. They point to the 2002 standard.
  • If quotes are unavailable in a stressed market, think of Loss under 1992 or model-based valuation under 2002.

Practice questions from Netting, Close-out and Related Aspects

Close-out Amount and Valuation at Default: frequently asked questions

What is the difference between ISDA 1992 and 2002 close-out methods?

The 1992 form lets parties choose Market Quotation or Loss. The 2002 form uses one Close-out Amount based on commercially reasonable procedures. The 2002 approach allows quotes, market data and internal models, so it works better in illiquid or stressed markets.

How do you calculate the close-out amount on default?

Value each terminated trade from the survivor's view, add unpaid amounts, and net everything into one figure. Then subtract collateral held. The result is the net claim or the amount owed back.

Why does the close-out period matter for valuation risk?

Market prices keep moving between the default and the unwind of the trades and hedges. A longer period means larger possible losses that collateral may not cover. Risk models capture this through the margin period of risk.

Can the defaulting party dispute the close-out amount?

Yes. Disputes usually focus on whether the survivor acted in good faith and used commercially reasonable procedures. Clear records of quotes, inputs and models make the figure easier to defend.