Final answer:
The notional principal in an interest rate swap is the hypothetical amount used to calculate the exchange of interest payments and is not the difference in interest rates or interest payments.
Step-by-step explanation:
In an interest rate swap, the notional principal is a hypothetical amount that is used to calculate the interest payments exchanged between parties in the swap agreement. The notional principal itself does not change hands; instead, it serves as the basis for determining the amount of interest payable. It's important to understand that the notional principal is neither the difference in the fixed and floating interest rates (option 1) nor the difference in the fixed and floating interest payments (option 2). Rather, the notional principal is similar to the principal amount in a simple interest calculation, where interest is calculated on the principal amount as outlined in the formula for simple interest.
To clarify, in a typical interest rate swap, one party will agree to pay a fixed interest rate on the notional principal, while the other party will pay a floating rate that is subject to change with market conditions. The actual cash flows exchanged are the differences in interest obligations, calculated based on the notional principal.