Notional Amount

What is the Notional Amount?

The notional amount refers to the predetermined dollar amount in an interest rate swap on which interest payments are based. It is the face value that is used to calculate interest payments on financial instruments.

The notional amount does not change hands, and therefore, no party pays or receives the amount at any time. The only transactions that change hands between the transacting parties are the interest rate payments. Essentially, the notional amount is the value of the asset that a person owns.

For example, if a person pays $1,000 for a bond, the notional amount of the bond is equivalent to the amount paid to purchase the bond, i.e., $1,000. The notional principal value is quoted by different financial instruments, such as swaps, options, and futures.

Understanding the Notional Amount

The notional amount is the assumed principal amount that is used as the base amount when calculating the exchanged interest amount. The principal amount is functionally separated from the transaction, and the only actual components in the transaction are the interest rate payments.

The notional amount is a theoretical figure employed only when calculating interest payments. When making the interest payments, the parties make reference to a specified index upon the notional amount for a promise to pay similar amounts.

The interest payable is based on the notional amount, which can be in any denomination. Also, the notional amount does not need to be a cash value, and it can be equivalent to the value of equity holdings.

Practical Example

Assume that two parties, Mary and John, enter into an agreement to exchange interest payments with each other.

• Mary holds an investment of $1,000,000 that pays SOFR + 1% annually. Because SOFR fluctuates, her interest payments vary with market rates.
• John holds a similar $1,000,000 investment that pays a fixed annual rate of 2%. His interest payments remain constant.

To manage their exposures, they enter into an interest rate swap. Under the swap:

• Mary agrees to receive a fixed 2% annually (matching John’s fixed return).
• John agrees to receive floating interest based on SOFR + 1%.

Since only interest payments are exchanged, calculations are based on the $1,000,000 notional amount, which is never exchanged.

Example Calculation

If SOFR averages 5.0%:

• Mary’s floating rate = 6.0% → $60,000 ($1,000,000 × 6.0%)
• John’s fixed rate = 2.0% → $20,000 ($1,000,000 × 2.0%)

Under the swap, the payments are netted:

• Mary owes John $60,000
• John owes Mary $20,000
• Net result: Mary pays John $40,000.

Applications of Notional Amount

The following are key examples of investments where the notional amount is used:

1. Interest Rate Swaps

An interest rate swap occurs when two parties lend funds to each other but with different terms, i.e., repayment schedule and interest rates. It helps shift the risk or returns of an investment to another party, where one investment comes with a variable rate of return, while the other party offers a fixed rate of return.

Such a type of arrangement benefits one party, with the other party suffering a loss. The notional amount is the theoretical amount on which the interest payments are based. The amount can be any currency or a combination of currencies.

2. Total Return Swaps

A total return swap is a financial contract that transfers the credit and market risk of an underlying asset. In a total return swap, one party makes interest payments based on a fixed or variable rate that is multiplied by the notional amount plus capital losses.

The other party in the contract calculates interest payments based on the return of the underlying asset, i.e., income generated plus capital appreciation, if any. The underlying asset can be a bond, loan, or equity index.

A total return swap is structured in a way that the parties earn interest from a reference asset without owning it. For example, if the underlying asset is a bond, Party A would pay Party B SOFR plus a spread multiplied by the notional amount plus capital losses. Party B would pay Party A the return of the underlying asset, including the income generated and the capital gains of the asset.

Additional Resources

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA®) certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

• Applicable Federal Rate (AFR)
• Compound Interest
• Interest Expense
• Equity Swap Contract
• Total Return Swap
• See all Fixed Income resources