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FRM Part I · FRM Exam Part I · Introduction to Derivatives

In a plain vanilla interest rate swap, Party A pays a fixed rate of 4% and receives 6-month SOFR-based floating payments on a notional principal of USD 50 million. Which statement best describes the notional principal?

The notional principal in a plain vanilla interest rate swap is only a reference amount for calculating interest payments. It is never exchanged, so the actual credit exposure is far smaller than the notional, being limited to the net value of the remaining payments.

  1. AIt is exchanged between the parties at inception and returned at maturity
  2. BIt is used only to calculate the interest payments and is not exchangedCorrect
  3. CIt is paid by the fixed-rate payer to the floating-rate payer at maturity
  4. DIt is the amount at risk of loss if the counterparty defaults

Explanation

In a plain vanilla interest rate swap, the notional is a reference amount used to compute the fixed and floating payments. No principal changes hands, so exchanging it (A) is wrong. Credit exposure is only the net value of the remaining payments, not the notional, so D is wrong.

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