Notional Principal Amount
What it is:
Notional principal amounts never change in an interest rate, and they are the core of the calculations involved in these transactions.
How it works/Example:
An interest rate 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 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 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 it matters:
The notional principal amount is the total dollar amount used to calculate the interest payments involved in an interest rate swap position.