Netting

Netting is a contractual arrangement between two parties. Essentially, it means that the parties have agreed that, when they transact with each other, they will not have individual cross-claims against each other. Instead, at any time there will be just one amount owed by the party whose notional cross-claim is worth less than its Counterparty's cross-claim.

Netting is extremely important in the context of Derivatives. For example, under a swap two parties agree to exchange payment streams. Each party to the swap makes regular payments to the other. The payments made under the swap by one party are calculated on a different basis to the payments made by the other party. For example, under the most common type of interest rate swap (known as a fixed to floating interest rate swap):

1. •

   one party makes regular payments by reference to a floating rate of interest, and

2. •

   the other party makes regular payments based on a fixed rate of interest

Depending on fluctuations in interest rates, either party could be in-the-money or out-of-the-money at any one time.

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