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CA Final · Advanced Financial Management · Derivatives Analysis and Valuation

Regarding the notional principal in a plain vanilla interest rate swap, which statement is correct?

The notional principal in a plain vanilla interest rate swap is only a reference amount used to compute the interest payments, and it is never exchanged. Both legs are in the same currency, so exchanging principal would be pointless. Only the net interest difference is settled.

  1. AIt is used only to compute the interest payments and is not exchanged between the partiesCorrect
  2. BIt is exchanged between the parties at inception and re-exchanged at maturity
  3. CIt is exchanged only at maturity, at the spot rate then prevailing
  4. DIt is paid by the fixed-rate payer to the swap dealer as initial margin

Explanation

In a plain vanilla interest rate swap both legs are in the same currency. Exchanging equal principal amounts would achieve nothing, so the notional is only a reference amount for calculating interest. Only the net interest difference is settled. Exchange of principal is characteristic of currency swaps, which makes the other options wrong.

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