A Brief Introduction About the Notional Principal Contract
What is a notional principal contract?
Notional Principal Contract is a contract where there is no property held by either party to the contract equal to the underlying value of the contract, which is why it is known as the notional principal.
What is a swap?
A swap is a kind of derivatives contract between two people where the value is based on cash flows. The cash flow of one party is fixed, while the cash flow of the other party is variable.
If we were to define swap, it is exchanging one thing for another. So in the case of a derivatives swap, it is the exchange of cash.
A bullet swap is a form of equity swap where the payments between the two parties are not settled at specific intervals but at the end of the contract through a single payment.
The interest rate swap tax treatment is similar to the taxation of financial instruments. Gains or losses are taxed at the income tax slab of the trader.
Who Takes the Notional Principal Contract? – People Involved
The parties involved in such contracts are traders who want to protect or hedge themselves against any adverse movements in the underlying product, which could be interest rates or equities.
The party which feels interest rates could fall will switch from a variable interest rate income stream to a fixed income one. The other party who feels that interest rates may rise will go for the floating rate scheme exchanging the fixed-rate one.
Purpose of the Notional Principal Contract – Why Do You Need It?
A notional principal agreement is made between two parties where there is an exchange of payments at specified intervals based on income streams generated from the principal. The principal is notional; it is not exchanged.
The simplest form of such contracts would be an interest rate swap. While one party pays the other party based on the value obtained through multiplying the floating interest rate and the notional value, the second party to the contract pays the first party the value derived by multiplying the notional amount with a fixed rate of interest.
If there was no agreement, then either party could default in payment on the due date. If interest rates went down, then the first party would gain from the contract as it opted for a fixed rate income stream to hedge itself against a fall in interest rates. However, there would be a loss if the second party did not pay up at the given interval.
Contents of the Notional Principal Contract – Inclusions
The contents of the notional principal agreement should include all clauses to protect the interests of both parties to the contract.
Here is the information that should be included in this contract:
- The effective date of the agreement
- The names of the parties to the contract
- Consideration
- Purpose of the contract
- Nature of the contract
- Tenure of the contract
- Governing laws
- Indemnity clause
- Limitation of liability clause
- Termination of contract
- Disclaimer
How to Draft the Notional Principal Contract?
While preparing a swap contract, you need to keep in mind the rules and regulations relating to derivatives.
Here are the points to be kept in mind while drafting the contract:
- Competence to contract
- Consideration involved
- Terms of the contract
- Confidentiality clause
- Dispute resolution clause
- Termination of contract
- Adherence to law
- Space for signature and dates
Negotiation Strategy
Before entering into this contract, both parties should examine all the clauses to the contract. The currency or interest rate or any other variable on which the contract is based should be negotiated before the contract is signed. The payment dates should also be decided so that both parties can gain from this agreement.
Benefits & Drawbacks of the Notional Principal Contract
Benefits
- Protection of interest
- Realization of gains
- Termination of contract
- Lower possibility of disputes
- Legal recourse
Drawbacks
- Possibility of non-payment: If there is no contract, then either party can delay the payment. In case of such contracts, if the payments are not made on the due dates, the losses could be huge for the affected party due to the volatile nature of futures and options markets
- No remedies: Without the contract, if there is a dispute between both parties, then the resolution would be extremely difficult. Taking legal action would not be possible
What Happens in Case of Violation?
In case of violation of this contract, both parties are affected greatly due to the nature of the markets in which the underlying products are transacted. If there is a delay in the settlement on the due date, the losses would be huge.
To begin with, the party that has violated the contract should be sent a contract violation letter. The details of the violation, including the clauses, should be mentioned in the letter with supporting documents. A possible solution could be suggested. If a resolution is not possible, then a letter terminating the contract should be sent.
The party violating the contract would have to pay monetary damages for the loss caused to the other party(1). The party who has suffered the loss would not then have to fulfill the duties mentioned in the contract.
A notional principal contract is entered into by traders participating in the futures and options market. These are high-risk markets, and in order to gain from them, the transactions must be carried out at the right time. Any delay in processing the transactions would result in high losses for both parties.
In order to protect the interests of both parties, it is important that the contract has all the relevant clauses.
There should be a dispute resolution clause where the process for settling the disputes, including deciding who will pay the attorney fees should be clearly mentioned.