What does the notional principal amount mean?
In an interest rate swap, the notional principal amount is the basis of interest payments. This refers to a principal or dollar amount that was already determined beforehand. But what does it when we say notional? In general, it refers to something that is only theoretical. So when we say notional principal in transactions, they never change hands. Thus, the term is named as notional or theoretical. No one pays or receives this notional principal amount at all times. Instead, the only ones that change hands are the interest rate payments.
Tell me more about the notional principal amount.
Notional principal amount refers to a financial instrument that gives payment from one party to another at certain intervals in exchange for a particular consideration or a promise for a similar payment. The interval calculation is based on a specified index upon a notional principal amount. This definition is according to treasury regulations.
Other people also define it as an assumed principal amount we can encounter in financial transactions even when working separately from the transaction. We also include the debt security’s underlying principal in interest rate swaps since rates are actual transaction components. On the other hand, the principal is not real. The notional principal amount does not even need to be an actual cash amount. It can also be equity holdings or the basket of stocks’ value, as long as the value is equal.
Bond payment calculations involve the bond’s face value as it is considered notional if we want to know the interest dues. These payments are a portion of that face value even when the face value is fictional. Also, this face value cannot be eliminated because it may even be nonexistent until the bond comes close to maturity. However, it has an understood value that is needed to get relevant calculations.
Notional principal payments and interest rate swaps
There are two organizations involved in every interest rate swap. They lend funds to each other, but the terms are not the same. And when we say terms, we may refer to the repayment schedule. They do not have similar durations and different interest rates. But what if the transaction encounters the same principal amount? Then, the principal is notional because it does not change hands. Sometimes, it does not even exist. The principal is the amount that one lends and another receives. Interest rate swaps help change the risk or return regarding investments up or down. In this case, one organization will have an asset that comes with a variable rate while the other has a fixed rate. One party may take advantage of the arrangement, while the other may lose money with agreements accepted as zero-sum.
A small recap for today
We can encounter notional principal amounts in interest rate swaps. These amounts can be theoretical, and each party pays to the other at specific intervals. When we say theoretical, this amount may not even exist yet. For example, the notional principal amount in bonds is similar to the face value of the bond.