The predetermined dollar amount in an interest rate swap on which interest payments are based
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The notional principal 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 principal 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 principal amount is the value of the asset that a person owns.
For example, if a person pays $1,000 for a bond, the notional principal 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.
The notional principal amount is the assumed principal amount of a financial contract on which the exchanged interest rates are based.
It is a theoretical amount that never changes hands between the parties.
The notional principal amount is used as the face value of a financial instrument when calculating the interest payments due.
Understanding the Notional Principal Amount
The notional principal 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 principal 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 principal for a promise to pay similar amounts.
The interest payable is based on the notional principal amount, which can be in any denomination. Also, the notional principal amount does not need to be a cash value, and it can be equivalent to the value of equity holdings.
Assume that two parties, Mary and John, enter into a contractual agreement to exchange interest payments with each other. Mary holds an investment that is valued at $1 million and earns an interest of LIBOR +1% every month. Since LIBOR changes periodically, the interest payments that Mary receives is not constant, and it changes with fluctuations in the market rates.
John, on the other hand, owns a similar $1,000,000 investment that pays a monthly interest rate of 2%. The interest payments that John receives remain constant throughout the year. Both parties agree to enter into an interest rate swap contract to exchange interest payments between themselves. It means that Mary will get a constant payment of 2% every month, whereas John will start receiving variable interest payments every month at the rate of Libor+1%.
Since the parties only agree to exchange interest rate payments, the interest is calculated on a $1,000,000 principal amount. The amount is the notional principal amount, and it is a theoretical amount that does not change hands between the counterparties.
If the LIBOR rate is 0.5% during the month of January, Mary will receive $15,000 in interest payments ($1,000,000 x (0.5% + 1%). In the same month, John will receive $20,000 in interest payments ($1,000,000 x 2%).
Under the terms of the interest rate swap agreement, Mary will pay John $15,000, while John will pay Mary $20,000. The transactions partially offset each other, and John will owe Mary $5,000 ($20,000 – $15,000) in interest payments.
Applications of Notional Principal Amount
The following are key examples of investments where the notional principal 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 principal 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 principal amount plus depreciation.
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 the LIBOR rate multiplied by the notional principal amount plus depreciation, while Party B would pay Party A the return of the underlying asset, including the income generated and the capital gains of the asset.
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