Breaking break clauses

The value of early termination clauses in derivatives depends crucially on the type of close-out value used and on the counterparty risk, and embeds optionality in even the most vanilla swap contracts. In the case of the so-called risk-free close-out, a deterministic default intensity model can be used to price them. By Lorenzo Giada and Claudio Nordio

The impact of close-out conventions consistent with International Swaps and Derivatives Association master agreements for derivative contracts, especially their effect on counterparty credit risk adjustment, has been studied in Brigo & Morini (2011) and Brigo, Buescu & Morini (2011). The choice between the so-called risk-free and substitution close-out values can have a large effect on pricing