:max_bytes(150000):strip_icc()/investing2-5bfc2b8fc9e77c005143f176.jpg "Notional Principal Amount: Definition, Calculations, Example")
What Is Notional Principal Amount?
The term notional principal amount refers to the predetermined dollar amount or principal on which exchanged interest payments are based. Notional principal amounts are commonly used between two parties in interest rate swaps. The notional principal amount is a theoretical value. This means while it is predetermined by parties in the swap, that dollar value isn’t exchanged. Rather, only the interest rate ever changes hands.
Key Takeaways
- A notional principal amount is the predetermined dollar value used in interest rate swaps.
- Interest payments that each party pays the other in an interest rate swap are based on the notional principal amount.
- Notional principal amounts are theoretical.
- In bonds, the notional principal amount is equal to the face value of a bond.
Understanding Notional Principal Amounts
An interest rate swap is a contract between two parties who agree to exchange future interest payments for another. These payments are based on a certain dollar value known as the notional principal amount. Treasury Regulations defines the notional principal amount as “a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount, in exchange for specified consideration or a promise to pay similar amounts.”
As noted above, the notional principal never changes hands, which is why it is considered notional or theoretical. Put simply, the notional principal is the assumed amount of principal involved in a financial transaction, even though it is functionally separated from the transaction. This means that the parties involved neither pay nor receive the notional principal amount at any time. Rather, they only exchange interest rate payments.
This concept can also be applied to the underlying principal value of a debt security in interest rate swaps. That’s because the rates are actual components of the transaction while the principal is functionally fictitious. A notional principal amount need not necessarily be a cash amount. It can also be equal to equity holdings or the value of a basket of stocks.
When calculating bond payments, a bond’s face value is considered notional when it comes to determining the interest due. The payments are a percentage of the face value, even if the face value is not available in a true sense. The face value cannot be withdrawn and may not even exist in a traditional sense until the bond approaches maturity, but it does have an understood value that is required for the performing of relevant calculations.
Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than would have been possible without the swap.
Special Considerations
An interest rate swap involves two parties who lend funds to one another but with different terms. The repayment schedule may be for different durations or different interest rates.
In cases where a transaction involves the same amount of principal (the amount being lent and received by each party), the principal is notional and does not actually change hands or may not even functionally exist. When the underlying asset is an amortizing loan, the underlying principal decreases in value over the repayment period. These swaps are amortizing swaps.
Interest rate swaps are often used to help shift the risk or return of particular investments up or down. One organization might have an asset with a variable interest rate, while the other holds an asset with a fixed rate. Accepted as a zero-sum agreement, one party may benefit from the arrangement while the other experiences a loss.
Example of Notional Principal Amount
Here’s a hypothetical example to show how the concept of a notional principal amount works. Let’s say two companies enter into an interest rate swap contract. The contract has the following conditions: For three years,
- Company A pays Company B 5% interest per year on a notional principal amount of $10 million for three years
- Company B pays Company A the one-year Secured Overnight Financing Rate (SOFR) on the same notional principal amount of $10 million for the same three years
This would be considered a plain vanilla interest rate swap because one party pays interest at a fixed rate on the notional principal amount and the other party pays interest at a floating rate on the same notional principal amount.
How Do Interest Rate Swaps Work?
An interest rate swap is a financial agreement between two parties. It is a forward contract, which means both parties pay each other interest at specified intervals in the future. These swaps are based on a predetermined dollar value called the notional principal amount. This value is theoretical, which means that it never changes hands. Rather, the two parties only pay each other the agreed-upon interest. Companies and financial institutions trade interest rate swaps to mitigate risk, hedge against loss, and manage credit risk.
What Does Notional Value Mean in Finance?
The term notional value is used to define the total value of an underlying asset in a financial contract. Put simply, it is the face value of a contract’s underlying asset. This value can be applied to different types of financial contracts, including interest rate swaps, equity options, and foreign currency derivatives. Traders can calculate the notional value of an asset by multiplying the contract size with the underlying asset’s price.
What Is the Best Way to Trade Interest Rates?
When you trade interest rates, you’re essentially betting on whether rates will move up or down. If you’re an experienced trader, consider investing in interest rate futures. These financial contracts are a little more complicated than the average security and often involve spread betting to speculate on the movement of interest rates.
But if you’re a novice investor or not that experienced, you can still take advantage of interest rate investing. Consider ETFs that are designed to move with increases in long-term interest rates, fixed-income securities, or index investing that mirrors interest rates.
The Bottom Line
An interest rate swap is a unique type of financial contract. It is an agreement between two parties who pay each other interest at regular intervals over the duration of the contract. The interest is based on the notional principal amount. This is a theoretical dollar value on which the interest rate is based. This amount is never actually traded or paid. Instead, the two parties in the contract pay the interest calculated on the notional principal amount to one another.