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

ISDA Master Agreement and Legal Framework for Netting

Updated 11 October 2026 · Fact-checked

The ISDA Master Agreement is a standard contract for OTC derivatives. All trades under it form a single agreement. On a default, close-out netting turns them into one net amount owed by one party. This cuts exposure only if courts in the relevant jurisdictions enforce netting, which legal opinions support.

Understand ISDA Master Agreement and Legal Framework

OTC derivatives are traded bilaterally. Without a standard contract, each trade would be a separate legal claim. The ISDA Master Agreement gives two firms one framework for all their trades. It is a pre-printed document, usually the 1992 or 2002 version, and it does not change between counterparties.

The Schedule is where the two parties tailor the Master Agreement. They choose things like additional termination events, cross-default thresholds, governing law (commonly English or New York law) and which party is the calculation agent. Each trade is then recorded in a short Confirmation. The Master Agreement, Schedule and Confirmations together form the contract.

The key legal idea is the single agreement concept. All transactions are stated to be one single agreement. This matters in insolvency. An administrator may want to keep trades that are profitable for the defaulter and drop the losing ones. This is cherry picking. Because the trades are one agreement, that is not allowed. They are all terminated together.

The agreement lists Events of Default, which are the fault of one party, such as failure to pay or deliver, breach of agreement, misrepresentation, cross-default, and bankruptcy. It also lists Termination Events, which are not anyone's fault, such as illegality, tax events and, if chosen, credit-event-upon-merger or ratings downgrades. On an Event of Default the non-defaulting party may designate an early termination date. It then values all trades and nets them to one close-out amount. Under a Termination Event the rights depend on whether one or two parties are affected.

Netting reduces credit exposure only if it is legally enforceable. Insolvency law differs by country. Banks therefore obtain legal opinions on each jurisdiction covering the counterparty's type and location. ISDA commissions such opinions. Under Basel rules, a bank may recognise netting for capital only if it has a well-founded legal basis for enforceability in all relevant jurisdictions. If netting fails in a jurisdiction, exposure must be taken gross for that counterparty.

Key formulas to remember

Net exposure with enforceable close-out netting: Net exposure = max(Σ MtM of all trades, 0); One payment is due on default. Positive and negative values offset across the whole netting set.
Gross exposure without netting: Gross exposure = Σ max(MtM of each trade, 0); Used when netting is not enforceable. Only positive trades count, since you still owe on the negative ones.
Netting benefit: Netting benefit = Gross exposure − Net exposure; It is never negative. It is zero if all trades have the same sign.
Netting ratio (NGR): NGR = Net exposure ÷ Gross exposure; Lies between 0 and 1. Lower means more benefit.
Single agreement rule: All trades under one Master Agreement = one contract; It blocks cherry picking and underpins close-out netting.

How to solve ISDA Master Agreement and Legal Framework questions

Most questions are either a legal-concept question or a small exposure calculation. Use this order for both.

1Identify what is asked: a legal term, a default or termination event, or a netting calculation.
2For legal terms, link the term to its job: Schedule customises, Confirmation records a trade, single agreement blocks cherry picking.
3For default scenarios, decide if the cause is a party's fault (Event of Default) or no one's fault (Termination Event).
4For calculations, list the mark-to-market of each trade in the same netting set with signs.
5Compute gross exposure (positives only) and net exposure (sum, floored at zero).
6Check whether netting is enforceable in the stated jurisdictions. If not, use gross exposure.
7State the interpretation: the netting benefit, and how the legal opinion supports it.

Quickest way: Sign check and enforceability check

When to use it: Use it for numerical netting questions and for scenario questions in the time-limited MCQ.

Read the question for any hint that netting is unenforceable. If so, answer with gross exposure.
Sum all values with signs. If the sum is negative, net exposure is zero.
Add only positive values for gross exposure.
Subtract to get the benefit, or divide for NGR.
For concept options, eliminate any answer that lets one party keep only favourable trades.

Common mistakes in ISDA Master Agreement and Legal Framework

Treating all termination causes as Events of Default.
Both end the trades, so they look alike.
Fix: Events of Default are a party's fault. Termination Events such as illegality or tax events are not. Ask who is at fault.
Thinking the Schedule is a separate contract from the Master Agreement.
The names sound like different documents.
Fix: The Schedule modifies the Master Agreement. Together with Confirmations they form one agreement.
Assuming netting always works because the ISDA is signed.
The contract is seen as the whole answer.
Fix: Enforceability depends on insolvency law. You need a legal opinion for each relevant jurisdiction, or exposure is gross.
Netting negative exposure to a negative number.
Students sum the trades and stop.
Fix: Net exposure is floored at zero. A negative sum means you owe the defaulter, not that you have a claim.
Confusing the single agreement concept with trades being identical.
The word single suggests one trade.
Fix: Many different trades are legally one contract. This stops the administrator from cherry picking.

Worked examples

Example 1

A bank has four OTC trades with Counterparty X under one ISDA Master Agreement. Mark-to-market values are +USD 12 million, +USD 5 million, −USD 9 million and −USD 4 million. Netting is enforceable. What are gross exposure, net exposure and the netting benefit?

Show the solution

Gross exposure counts only positives: 12 + 5 = USD 17 million.
Sum all trades: 12 + 5 − 9 − 4 = USD 4 million.
Net exposure = max(4, 0) = USD 4 million.
Netting benefit = 17 − 4 = USD 13 million.

Answer: Gross exposure is USD 17 million, net exposure is USD 4 million, and the netting benefit is USD 13 million.

Example 2

A bank holds two trades with a counterparty: +EUR 8 million and −EUR 10 million. The counterparty becomes insolvent. Local law may allow its administrator to keep one trade and cancel the other. The bank has no legal opinion for that country. What exposure should the bank report for capital, and why?

Show the solution

Without a legal opinion, enforceability of close-out netting is not established.
Exposure is therefore taken gross: only the positive trade counts.
Gross exposure = EUR 8 million.
If netting were enforceable, the sum would be 8 − 10 = −2, and net exposure would be zero.

Answer: The bank should report EUR 8 million, since netting cannot be recognised. With a valid opinion it would be zero.

Exam tips

Know which items are Events of Default and which are Termination Events. Examiners test the line between them.
If the question mentions a jurisdiction without a legal opinion, expect gross exposure to be the answer.
Link single agreement to cherry picking. It is the most common conceptual question.
In calculations, always floor net exposure at zero and count only positives for gross.
Remember that the Schedule customises the agreement, for example governing law and cross-default thresholds.

Practice questions from Netting, Close-out and Related Aspects

ISDA Master Agreement and Legal Framework: frequently asked questions

What is the ISDA Master Agreement?

It is a standard legal contract for OTC derivatives between two parties. It sets terms for payments, defaults, termination and close-out. Trades are added as Confirmations.

What is the single agreement concept?

All trades under one Master Agreement are treated as one contract. If a party defaults, all trades are terminated and netted together. The administrator cannot cherry pick.

What is the difference between an Event of Default and a Termination Event?

An Event of Default is caused by a party, such as failure to pay or bankruptcy. A Termination Event is not the fault of a party, such as illegality or a tax event. The consequences and the calculation of amounts differ.

Why do banks need legal opinions on netting?

Insolvency laws differ by country and may not enforce close-out netting. Opinions confirm that netting will hold for given counterparties and jurisdictions. Without them, regulators require gross exposure.