Notional Principal Amount

What it is:

Notional principal amounts never change in an interest rate swap, and they are the core of the calculations involved in these transactions.

How it works (Example):

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 it Matters:

The notional principal amount is the total dollar amount used to calculate the interest payments involved in an interest rate swap position.