Breakage costs
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Loans
Breakage costs, or break costs, on a loan are the opportunity cost to a lender of a borrower repaying a loan before scheduled maturity, meaning the lender must unwind its interest rate hedges - usually the difference between the rate payable on the loan for the specified period and the overnight rate.
The difference between the present value of the remaining loan repayments at their stated rate and their present value at the prevailing market rate — that is, the difference between present value of what i would get if we stuck with the original deal and you repaid the loan at term, and how much i could get if I lent that money out today, at today’s rate, for the period of the remaining term on the original loan.
Swaps
Swap break costs are the equivalent for a swap. Since a swap has cash flows running in both directions, the present value of which on the trade date must have been equal, the theory is therefore that any swap must have a mark-to-market value of zero on day 1, swap break costs will generally be simply the uncollateralised mark-to-market value, or the replacement cost, of the existing transaction. You could reach that conclusion by going through the motions:
- If I terminated this swap today, what would its MTM be? This is the equivalent of “the present value of the remaining payments".
- If I traded a new swap at today’s prices, what would its MTM be? According to the theory of homo economicus, this ought to be necessarily zero — any other value would mean I was entering into an off-market swap.[1]