What is the notional principal amount?
The notional principal amount (also called notional amount, notional principal, or notional value) refers to the nominal value or face value that is used to determine interest payments of financial instruments. The notional value can also be described as the total value of a position in a financial instrument or the amount of money controlled by a position in a specific security. In finance, the term notional is used to indicate a reference amount or an estimate.
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The basics of the notional principal amount
The notional amount is considered a theoretical amount because it is never transferred at any time from one party to another party in a financial transaction, meaning neither party pays nor receives the notional principal amount. The principal amount is effectively detached from the transaction, and the only actual payments involved in the transaction are the interest payments, which change hands between the parties involved in the transaction. The notional principal amount can be in any denomination (currency), such as the euro, the US dollar, or the South African rand. In addition, it is not required that the principal amount be a cash value, and it can be equal to the value of equity holdings. It can also have any value.The uses of notional principal amount
The notional value is used in various financial transactions. For example, interest rate swaps, total return swaps, currency swaps, equity options, derivative contracts, and bonds.Interest rate swaps
An interest rate swap refers to a financial transaction in which two parties lend funds to each other but with different terms such as different durations and/or different interest rates. The parties involved agree to exchange future interest rate payments, calculated periodically by multiplying the applicable interest rates by the predetermined notional principal value. Interest rate swaps help to transfer the risk or return(s) of a specific investment from one party to another party, where one investment has a variable rate of return, while the other party holds an investment with a fixed rate of return. Assuming it is a zero-sum agreement, one party may benefit from the arrangement while the other party incurs a loss. Example of interest rate swap: Two investors, Kane and Joshua, decide to exchange interest payments with each other and subsequently enter into a contractual agreement. Let us say, Kane has an investment valued at R1 000 000 and earns an interest rate of 1.50 percent per month. The interest rate is a floating (variable) rate. Hence, the interest payments received by Kane change according to fluctuations in the market interest rates. Joshua also invested R1 000 000 but with a monthly interest rate of 1.25 percent. Joshua’s interest payments stay constant throughout the year. Kane decides that he would prefer a constant interest rate payment, while Joshua decides that he would rather take a chance on receiving higher interest payments, although not constant. Hence, the two parties decide to enter into an interest swap rate contract. In terms of their contract, Kane commits to pay Joshua 1.50 percent per month on the notional principal amount (R1 million), while Joshua agrees to pay Kane 1.25 percent per month on the principal amount (R1 million). Kane receives R15 000 (R1 000 000 x 1.50%) per month on his investment, while Joshua pockets a monthly interest payment of R12 500 (R1 000 000 x 1.25%) on his investment. According to the swap agreement, Joshua is required to pay Kane R12 500 per month, while Kane’s obligation is to pay Joshua R15 000 per month. The two amounts partially counterbalance, and Kane eventually owes Joshua the difference of R2 5000 (R15 000 less R12 500) per month. Let us now assume that Kane’s floating interest rate of 0.75 percent has decreased to 0.75 percent a month (a decrease of 75 percentage points). Kane now receives R7 500 (R1 000 000 x 0.75%) per month, while Joshua’s income regarding interest payments is still R12 500 per month. In terms of their swap agreement, Kane now needs to pay Joshua R7 500 per month, while Joshua’s obligation to Kane remains at R12 500 per month. The two payments partially offset each other, and Joshua now owes Kane the difference of R5 000 (R12 500 less R7 500) per month.Total return swaps
The purpose of a total return swap is to transfer the credit and market risk of an underlying asset. It is a financial contract that specifies, inter alia, the following:- One party involved in the transaction is required to pay interest payments based on a fixed or variable (floating) interest rate, multiplied by the notional principal amount plus depreciation.
- The other party in the contract calculates interest payments according to the return of the underlying asset (financial instrument), comprising income generated plus capital appreciation, if any. The underlying instrument can be a loan, equity index, or bond.
Currency swaps
A currency swap, occasionally called a cross-currency swap, is a type of interest rate swap, involving the exchange of interest payments (and sometimes the principal) of one currency for the same in another currency. For instance, US dollar versus the euro. Just like interest rate swaps, the calculation of interest rate payments for the currency swaps is also based on the pre-established notional principal amounts. Currency swaps comprise two notional values expressed in two different currencies (monetary units). Different from interest rate swaps, currency swaps also entail the exchange of notional principal values. Interest rate variations applied for currency swaps include variable (floating) rate to variable rate, fixed rate to fixed rate, or fixed rate to floating rate.Equity options
Equity options (also called stock options) offer investors the following options:- Call options (calls) give the holder the right, but not the obligation, to buy the underlying stock (shares) at a specified price at a date in the future.
- Put options (puts) provide the holder with the right, but not the obligation, to sell the underlying stock (shares) at a predetermined price at a specified date in the future.
Derivative contracts
A derivative contract is a financial instrument whose value is derived from the value of one or more underliers, which can be indices, stocks (shares), bonds, and currencies, to name a few. Common examples of derivative contracts, also called derivative instruments, are forward contracts (forwards), future contracts (futures), options contracts (options), and swap contracts (swaps). The notional principal amount of a derivative contract is the value of the underlying asset multiplied by the number of units of the underlying instrument (asset) involved in the contract.Bonds
Regarding bonds, the notional principal amount of the bond equals the amount paid to buy the bond. For instance, if an investor pays R20 000 for a bond, the notional principal amount is equivalent to R20 000. The bond payments are a percentage of the notional value (face value), even when the notional value is not available in the true sense of the word. The notional value cannot be withdrawn until the bond reaches maturity.
Difference between notional value and market value
Both terms describe the cost of a financial instrument (such as a security). However, they are used in different situations. As already mentioned, notional value refers to the value of a position in a financial instrument. Put differently, notional value can be considered as the theoretical value of a position in securities. Contrarily, market value indicates the price a financial instrument (asset) gets in a financial market, determined by buyers and sellers. Put in other words, market value is the price of a financial instrument at which it can be purchased or sold. Hence, market value is the actual value of a position in securities.Notional principal amount: important or irrelevant?
There are different opinions about the importance or irrelevance of the notional principal amount in the financial world.- Importance of notional principal amount:
- Companies involved in business operations in foreign countries often use currency swaps to obtain more favourable loan rates in the local currency than if they borrowed money from local financial institutions.
- Notional principal amounts are important in the calculations of numerous financial transactions such as interest rate swaps, total return swaps, currency swaps, equity options, and derivative contracts, to name a few.
- Notional value is an important guideline for investors, typically when assessing investment risk. It can be used to calculate hedge ratios and counteract portfolio risk.
- Irrelevance of notional principal amount:
- It doesn’t take into account the risk that the parties to a financial contract bear.
- In the case of contracts relating to interest rate swaps, it is not the notional value that plays an important role. Instead, fluctuation in the LIBOR rate acts as a real game-changer.’
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