Notional Principal Amount
What Is Notional Principal Amount?
The notional principal amount, in a interest rate swap, is the foreordained dollar amounts, or principal, on which the exchanged interest payments are based.
Understanding Notional Principal Amounts
The notional principal never changes hands in the transaction, which is the reason it is thought of as notional, or hypothetical. Neither party pays nor gets the notional principal amount whenever; just interest rate payments change hands.
As per Treasury Regulations, a notional principal amount is "a financial instrument that accommodates the payment of amounts by one party to one more at determined stretches calculated by reference to a predefined index upon a notional principal amount, in exchange for indicated consideration or a guarantee to pay comparative amounts."
Notional principal alludes to the assumed amount of principal engaged with a financial transaction, even however it is practically separated from the transaction. This can remember the underlying principal for a debt security in interest rate swaps, as the rates are genuine components in the transaction, however the principal is practically fictitious. A notional principal amount need not really be a cash amount. It can likewise be equivalent to equity holdings or the value of a basket of stocks.
While ascertaining bond payments, the face value of the bond is viewed as notional concerning deciding the interest due. The payments are a percentage of the face value, even on the off chance that the face value isn't accessible from a true perspective. The face value can't be removed and may not even exist from a traditional perspective until the bond approaches maturity, yet it has a perceived value that is required for the performing of important estimations.
Interest Rate Swaps
An interest rate swap includes two organizations lending funds to one another however with various terms. The repayment schedule might be for various terms or for various interest rates. In situations where the transactions include a similar amount of principal (the amount being loaned and received by each party), the principal is notional in nature and doesn't really change hands, or may not even practically exist.
Frequently, interest rate swaps are utilized to assist with shifting the risk or return of specific investments up or down, where one organization will have an asset with a variable rate while different holds an asset with a fixed rate. Accepted as a zero-sum agreement, one party might benefit from the arrangement while different encounters a loss.
Illustration of Notional Principal Amount
Two companies could go into an interest rate swap contract as follows: For three years, Company A pays Company B 5% interest each year on a notional principal amount of $10 million. For similar three years, Company B pays Company A the one-year LIBOR rate on a similar notional principal amount of $10 million.
This would be considered a plain vanilla interest rate swap since one party pays interest at a fixed rate on the notional principal amount and the other party pays interest at a floating rate on a similar notional principal amount.
Features
- Notional principal amounts are utilized in interest rate swaps.
- Notional principal amounts are the hypothetical value that each party pays interest to the next at determined stretches.
- In bonds, the notional principal amount is equivalent to the face value of a bond.
