For example, on Dec. 31, 2006, Company A and Company B enter into a five-year swap with the following terms:
Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million.
Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million.
LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits made by other banks in the eurodollar markets. The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate. For simplicity, let's assume the two parties exchange payments annually on December 31, beginning in 2007 and concluding in 2011.
At the end of 2007, Company A will pay Company B $20,000,000 6% = $1,200,000. On Dec. 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 (5.33% + 1%) = $1,266,000. In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period. Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A pays nothing. At no point does the principal change hands, which is why it is referred to as a "notional" amount.