What it means
In a swap, two parties agree to exchange cash flows based on different rates. One might pay a fixed interest rate while the other pays a floating rate, and both rates are applied to the same notional amount.
The notional amount is the base that makes those percentage rates into actual dollar payments. Because the notional is not lent or borrowed, it can be very large relative to the cash that actually moves.
A swap with a $50,000,000 notional might result in a net payment of only a few hundred thousand dollars in a period, since only the difference between the two interest calculations is usually settled. This is why headline notional figures overstate the true money at risk.
Businesses use notional-based contracts to manage risk. A company with a floating-rate loan can swap into a fixed rate to protect its budget from rising rates, and the notional is usually set to match the loan balance.
If the notional is too high or too low, the hedge will not match the exposure it was intended to cover. Notional amounts may be fixed, or they may change over time.
In an amortising swap, the notional falls in line with a loan being repaid, while in an accreting swap it grows in step with a drawdown schedule. The terms should be matched carefully to the underlying exposure.
Analysts watching derivative markets often quote total notional outstanding, but this figure is not the same as market value or credit exposure. The real exposure is usually the amount one party would lose if the other defaulted, which is generally a small fraction of the notional.
Documentation matters as well. The notional, the payment dates, the rate definitions and the day count convention are all set out in the swap confirmation, and the finance team should check that these match the loan being hedged.
In practice
Real-world examples.
Example
A property company has a $25,000,000 floating-rate loan and enters a swap with the same notional to fix its borrowing cost. Each quarter only the difference between the fixed and floating payments is settled with the swap bank.
Example
A manufacturer sets up an amortising swap that starts with a notional of $8,000,000 and falls by $1,000,000 each year. The falling notional matches the scheduled repayment of the underlying term loan.
Example
An investment bank reports that it has $200,000,000,000 of notional swaps outstanding. The risk team explains to the board that the actual credit exposure is much smaller, since most trades offset each other and only net values matter.
Formula
Calculation
Periodic payment = Notional principal amount x Interest rate x Fraction of the year
Suppose a company has a $10,000,000 notional interest rate swap in which it pays a fixed 4% and receives a floating rate that resets to 3.5% for the year. Fixed payment = $10,000,000 x 0.04 = $400,000. Floating receipt = $10,000,000 x 0.035 = $350,000. The net settlement is $400,000 - $350,000 = $50,000 paid by the company, while the $10,000,000 itself never changes hands.Case study
Seen in the real world.
Harlow Logistics is a fictional trucking company with a $15,000,000 floating-rate loan. Worried about rising rates, its finance director arranged a swap with a notional of $15,000,000 and a term of five years. The board was initially alarmed by the size of the contract and asked whether the company had taken on a $15,000,000 obligation.
The finance director explained that the notional was only a reference number and that the real cash flow was the difference between the two interest payments. In this illustrative story, interest rates rose over the first year and the company received net payments that offset its higher loan interest, so its overall cost stayed close to the fixed rate it had planned.
The board later asked for a simple quarterly report showing the notional, the fixed and floating rates, and the net payment for each swap. This gave directors a clear picture without having to read the full swap confirmation each time.
Watch out
Common mistakes.
- Believing the notional amount is exchanged. In most swaps, only the net interest difference is paid, not the notional itself.
- Treating notional as the amount at risk. The real exposure is the possible loss on the contract, which is typically far smaller.
- Setting the notional without matching the underlying loan. A mismatch leaves part of the exposure unhedged or creates an over-hedge.
Questions
People also ask.
Why do some contracts exchange the notional?
Currency swaps often exchange principal amounts at the start and end because the two currencies have different values.
Is notional the same as face value?
Not exactly; face value is the amount a bond repays at maturity, while notional is only a calculation base in a derivative.
How do banks use notional amounts?
They use them to size trades, set limits and report derivative activity to regulators.
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