In derivative trading, there is a kind of contract known as a "swap." Here's an oversimplified definition: these deals involve people (well, usually they involve financial institutions, but banks are people too, right?) trading something that they eventually plan on trading back. Essentially, they are trading use of a thing, but not the thing itself.
Think of it like mutual borrowing. Saying to a friend "hey, let me borrow your car today and I'll let you watch a movie on my high-tech home theater system." This is a swap. You and your friend get use of each other's stuff for limited period of time.
Don't feel bad if that all hasn't sunk in. The derivatives market itself can get somewhat confusing, and swaps possibly represent the most confusing part. But for defining this term, the key for a swap is that there is a time limit. An expiration.
But sometimes these swaps get ended earlier than expected. Say something comes up that interrupts operation of one of the items in a swap, like a bankruptcy or a merger. Because of the early termination, one side owes the other side something as compensation.
In the example we discussed, you borrowed your friend's car, as you guys agreed, but while driving around you get a call: "hey, the power went out. I can't watch the movie." You got to use the car, but your friend didn't get their movie. You need to come up with something else to give them.
The Agreement Value Method is one of the ways to figure out what's owed when a swap ends early. (And an obviously dangerous one, because when two parties just agree on some value of an esoteric property, there is a kind of confusion-liability embedded in that agreement, as it's likely that, down the line, somebody will feel screwed.) Specifically, the International Swaps and Derivatives Association has three approved methods for figuring out termination payments when a swap ends prematurely. The Agreement Value Method is the most common one. (The others, by the way, consist of the Indemnification Method and the Formula Method, but we won't go into those here.)
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Finance: What is the Difference Between ...42061 Views
finance a la shmoop. what's the difference between market value and book
value? ever tried to sell sunscreen to a white Walker? yeah [zombie walks through snow]
probably won't make much money. want to know why? now learning about the
difference between market value and book value will tell it all. first market
value it's what the market thinks a stock or a bond or a home or a used car
or whatever is worth. the market the crowd the crazy people.
all right here's an example of market value gone wild in the 17th century [crowd then tulip pictured]
Denmark, they valued a single tulip at 10 grand and it didn't even give them a
triple espresso buzz. go figure. but that's how the market of buyers
valued that tulip so that's what that tulips market value was. that's what the
market said it was worth. Book value however is a completely different in a [man walks through art gallery]
somewhat more rational animal .book value is the dollar amount that a company can
point to which reflects an asset they physically own. imagine buying a tractor
factory for 80 million bucks. it depreciates in value 10 million dollars
a year for 4 years then depreciates that 2 million dollars a year after that. so
after five years that factories Book value ie the amount we're guessing its [chart showing depreciation]
value as actually being is 38 million dollars. but lo and behold the factory
itself is made of Valyrian steel .you know that stuff from Game of Thrones
that kills White Walkers. so after eight years and one white Walker invasion of
Chicago later you decide to sell the factory itself because well the stuff [zombies walk in front of skyscrapers]
it's built out of, that rare material, is suddenly worth a lot more than the
factory .now after eight years the book value of the factory might be 32 million
dollars, but some bitter on eBay of tractor companies offers you a hundred
million bucks! and you accept! that hundred million dollars was the market [man sits behind computer screen]
value of the tractor factory even though the book value said it was worth a whole
lot less. securities actually work the same way. they are traded regularly in a
market place and they reflect their market value even though the book value
at which they are held is often a lot less. and what about Chicago well let's [smiling man carries bags of cash]
just say no one's selling much sunscreen these days.
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