Notional principal amounts are the theoretical value that each party pays interest to the other at specified intervals.
In bonds, the notional principal amount is equal to the face value of a bond.
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.
According to Treasury Regulations, a notional principal amount is “a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount, in exchange for specified consideration or a promise to pay similar amounts.”
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. A notional principal amount need not necessarily be a cash amount. It can also be equal to equity holdings or the value of a basket of stocks.
When calculating bond payments, the face value of the bond is considered to be notional in regard 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 The face value cannot be withdrawn and may not even exist in a traditional sense until the bond approaches maturity, but it does have an understood value that is required for the performing of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.
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 or 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.
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.