What does the term 'notional principal' refer to in financial swaps?

'Notional principal' refers to a hypothetical amount used to calculate the cash flows exchanged in financial swaps. It is important to understand that this amount does not change hands; instead, it serves as a reference point for determining the payments made between the parties involved in the swap agreement.

In the context of interest rate swaps, for example, the notional principal is the amount upon which interest payments are based. If two parties agree to swap interest payments, the actual payments are calculated using this notional amount, even though that amount itself is not exchanged.

This distinction is crucial because it underlines how swaps function: the notional principal acts as the framework for calculating the various cash flows without requiring the physical exchange of that principal. Thus, choice C accurately captures the essence of what notional principal means in the context of financial swaps.