What is the 'Notional Principal Amount'

The notional principal amount, in an interest rate swap, is the predetermined dollar amounts on which the exchanged interest payments are based. The notional principal never changes hands in the transaction, which is why it is considered notional, or theoretical. Neither party pays nor receives the notional principal amount at any time; only interest rate payments change hands.

BREAKING DOWN 'Notional Principal Amount'

For example, two companies might enter into an interest rate swap contract as follows: For three years, Company A pays Company B 5% interest per year on a notional principal amount of $10 million. For the same three years, Company B pays Company A the one-year LIBOR rate on the same notional principal amount of $10 million. 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.

Notional principal refers to the assumed amount of principal involved in a financial transaction, even though it is functionally separated from the transaction. This can include the underlying principal in a debt security in interest rate swaps, as the rates are actual components in the transaction, but the principal is functionally fictitious.

Interest Rate Swaps

An interest rate swap involves two organizations lending funds to each other but with different terms. The repayment schedule may be for different durations or for different interest rates. In cases where the transactions involve the same amount of principal (the amount being lent and received by each party), the principal is notional in nature and does not actually change hands, or may not even functionally exist.

Often, interest rate swaps are used to help shift the risk or return of particular investments up on down, where one organization will have an asset with a variable 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.

Notional Principal Amount and Bond Issues

When calculating bond payments, the face value of the bond is considered to be notional in regards 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 The face value cannot be withdrawn and may not even exist in a traditional sense until the bond approaches maturity, but it does have an understood value that is required for the performing of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.

RELATED TERMS
  1. Fixed Price

    The leg of a swap that is based on an unchanging interest rate. ...
  2. Notional Value

    The total value of a leveraged position's assets. This term is ...
  3. Currency Swap

    A swap that involves the exchange of principal and interest in ...
  4. Airbag Swap

    An interest rate swap whose notional value adjusts according ...
  5. Swap

    A swap is a derivative contract through which two parties exchange ...
  6. Liability Swap

    An exchange of debt related interest rates between two parties ...
Related Articles
  1. Trading

    How Are Interest Rate Swaps Valued?

    When trading in financial markets, higher returns are generally associated with higher risk. Hedge your risk with interest rate swaps.
  2. Investing

    How To Read Interest Rate Swap Quotes

    Puzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes
  3. Investing

    Inflation Protected Securities: How They Work

    Learn how the U.S. Treasury inflation-protected securities (TIPS) work, which considerations investors should keep in mind and for whom TIPS are most suitable.
  4. Personal Finance

    How Interest Rates Work On a Mortgage

    A step-by-step explanation of the interest calculations, mortgage types, and how the loan is eventually "retired" – which means paid off.
  5. Trading

    Introduction To Counterparty Risk

    Unlike a funded loan, the exposure from a credit derivative is complicated. Find out everything you need to know about counterparty risk.
  6. Insurance

    Brokerage Functions: Underwriting And Agency Roles

    Learning about these various activities can give insight into how securities are issued and traded.
  7. Personal Finance

    Interest-Only Mortgages: Home Free or Homeless?

    These loans can be beneficial, but for many borrowers, they present a financial trap.
  8. Personal Finance

    Simple Interest Loans: Do They Exist?

    Yes, they do. Here is what they are – and how to use them to your advantage.
  9. Investing

    4 Ways Simple Interest Is Used In Real Life

    Simple interest works in your favor when you're a borrower, but against you when you're an investor.
RELATED FAQS
  1. Notional value versus market value

    Learn about notional and market value, how to calculate the notional value of a futures contract and understand the difference ... Read Answer >>
  2. How does an entrepreneur choose a business structure?

    Learn more about interest rate swaps and currency swaps, how these swaps are used and the difference between interest rate ... Read Answer >>
  3. How do currency swaps work?

    Learn about how a currency swap works, including who uses these transactions, and the mechanics and purpose of the different ... Read Answer >>
Hot Definitions
  1. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  2. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  4. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
  5. Price Elasticity of Demand

    Price elasticity of demand is a measure of the change in the quantity demanded or purchased of a product in relation to its ...
  6. Sharpe Ratio

    The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.
Trading Center