A master netting agreement is an arrangement between two parties -- known as counterparties -- that governs the treatment of certain offsetting transactions or contracts. Two transactions offset each other if a gain in one results in a loss in the other. In other words, the transactions hedge each other. A master netting agreement requires a practice called "net settlement" should one of the counterparties default on or terminate any contract included within the master netting agreement.
Under net settlement, the counterparties add up the net amount of money due as a result of all the contracts within the master netting agreement. The counterparty that owes money is obligated to settle its debt through a single payment in a single currency to the other counterparty. Normally, the contracts within a master netting agreement involve derivative financial instruments, including futures, options, swaps, convertible securities and other contracts in which the value of the derivative stems from the value of a related, underlying security. In addition, repurchase-reverse repurchase agreements and securities borrowing-lending agreements are often included in master netting agreements. Two manufacturers might set up a master netting agreement if they act as mutual suppliers and customers to each other.