Upon entering into an interest rate swap with a notional principal of $10,000,000, what is the initial amount of money the counterparties must…

An interest rate swap is a derivative contract where two parties agree to exchange interest payment streams based on a specified principal amount. This principal is "notional" because it is a reference amount for calculating interest payments and is not actually exchanged between the counterparties. A standard, at-market ("plain vanilla") interest rate swap is structured so that the net present value of the future payments is zero for both parties at the inception of the contract. Consequently, there is no initial exchange of money.

B. $5,000,000: The notional principal is not exchanged, in whole or in part, in a standard interest rate swap.

C. The future value of $10,000,000: The principal is not exchanged, so its future value is irrelevant to the initial cash flow of the swap.

D. $10,000,000 discounted: The swap is designed to have a zero net present value at initiation, so no discounted principal payment is required.

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1. Association for Financial Professionals (AFP). (2020). Essentials of Treasury Management (6th ed.). Chapter 8: Financial Risk Management

Section: Interest Rate Swaps. The text states

"The notional principal in a swap is the amount used to calculate the interest payments. It is important to note that the notional principal is not exchanged between the counterparties."

2. Hull

J. C. (2018). Options

Futures

and Other Derivatives (10th ed.). Pearson. Chapter 7

"Swaps

" Section 7.2

p. 156. The text explains that a key feature of a standard interest rate swap is that it is structured to have a value of zero at the outset

hence no initial payment is made by either party.

3. Tuckman

B.

& Serrat

A. (2011). Fixed Income Securities: Tools for Today's Markets (3rd ed.). Wiley. Chapter 10

"Interest Rate Swaps and Other Derivatives

" p. 229. The authors state

"An at-market swap is a swap with a fixed rate set so that the value of the swap is zero. Unless otherwise specified

the word 'swap' will refer to an at-market swap."