Notional Principal Amount

To get to this one, we have to plow through a little background info on interest rate swaps.

An interest rate swap involves two parties trading the proceeds from debt instruments they own. They don't swap the actual instruments...just the money they earn from them. Usually, one side of the deal has a fixed-rate investment and the other side has an adjustable-rate one. The fixed-rater wants to live it up a little, take on the extra risk (and extra potential upside) of the adjustable-rate situation. Meanwhile, the adjustable-rater wants to slow down a bit and live a more stable lifestyle...get the sure-thing confidence that comes with a fixed-rate investment. The notional principal amount represents the underlying dollar value of the debt instruments being swapped.

You own a 10-year note with a fixed interest of 7.5%. Your buddy has a 10-year adjustable-rate note currently paying 8%. You both agree to an interest rate swap. You'll receive the proceeds from the 8% rate, though you accept that the number might change over time because it's an adjustable rate. Meanwhile, your pal will now receive your steady-eddy 7.5% fixed rate. You agree to a notional principal amount of $5,000. That might not represent the total value of the debt instruments you hold. Your 10-year note might be worth $20,000 and your friend might hold a $15,000 note. But for the purposes of the swap, you both agree that you're just paying on an underlying value of $5,000. So, in the first year, you send them a check of $375 (7.5% of the notional principal amount of $5,000). Meanwhile, your friend sends you a check of $400 (8% of the $5,000 figure).