What is the Notional Principal Amount?
The notional principal amount is the total dollar amount used to calculate the interest payments involved in an interest rate swap position.
How Does the Notional Principal Amount Work?
An interest rate swap is a contractual agreement between two parties to exchange interest payments. Let's assume that Charlie owns a $1 million investment that pays him LIBOR + 1% every month. As LIBOR goes up and down, the payment Charlie receives changes. Now assume that Sandy owns a $1 million investment that pays her 1.5% every month. The payment she receives never changes.
Charlie decides that that he would rather lock in a constant payment and Sandy decides that she'd rather take a chance on receiving higher payments. So Charlie and Sandy agree to enter into an interest rate swap contract.
Under the terms of their contract, Charlie agrees to pay Sandy LIBOR + 1% per month on a $1 million principal amount. This is the notional principal amount. Sandy agrees to pay Charlie 1.5% per month on the $1 million.
Let's say Charlie receives a monthly payment of $12,500 from his investment ($1,000,000 x (0.25% + 1%)). Sandy receives a monthly payment of $15,000 from her investment ($1,000,000 x 1.5%).
Now, under the terms of the swap agreement, Charlie owes Sandy $12,500 ($1,000,000 x LIBOR+1%) , and she owes him $15,000 ($1,000,000 x 1.5%). The two transactions partially offset each other and Sandy owes Charlie the difference: $2,500. The calculation agent keeps tabs on the swap, makes the calculation that Sandy owes Charlie $2,500, and ensures the payment is made.
Why Does the Notional Principal Amount Matter?
Notional principal amounts never change in an interest rate swap, and they are the core of the calculations involved in these transactions.
