Notional amount
Encyclopedia
The notional amount on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument. This amount generally does not change hands and is thus referred to as notional.
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In simple terms the notional principal amount is essentially how much of the asset or bonds a person has. For example, if a premium bond was bought for £1 then the notional principal amount would be £1. Hence the notional principal amount is the quantity of the assets and bonds.
, the notional principal amount is the specified amount on which the exchanged interest payments are based; this could be 8000 US dollars, or 2,7 million pounds sterling, or any other combination of a number and a currency. Each period's rates are multiplied by the notional principal amount to determine the height and currency of each counter-party's payment. A notional principal amount is the amount used as a reference to calculate the amount of interest due on an 'interest only class' which is not entitled to any principal.
, one party pays a fixed or floating rate multiplied by a notional principal amount plus the depreciation, if any, in a notional amount of property in exchange for payments by the other party of the appreciation, if any, on the same notional amount of property. For example, assume the underlying property is the S&P 500 stock index. A would pay B LIBOR times a $100 notional amount plus depreciation, if any, on a $100 notional investment in the S&P 500 index. B would pay A the appreciation, if any, in the same notional S&P 500 investment.
If you are buying stock option contracts, for example, those contracts could potentially give you a lot more shares than you could control by buying shares outright. So the Notional Value is the value of what you control rather than the value of what you own.
So for instance if you purchase 1 equity call option for a stock that is currently trading at $60 (with a strike of $60), then you have the same upside potential as someone who holds $6,000 of stock, but you may have paid only $5/option (for a total of $500), so by this measure you have achieved leverage
of $6,000/$500 = 12x. Note that if the stock price moves to $70, your dollar notional is now $7,000 (- cost of option and commission differential), but your quantity (unit notional) is still 100 shares.
Suppose you have a call option on USD/JPY struck at 110, and you buy one of these. Then this gives you the option to pay 100 USD and receive 110 x 100 = 11,000 JPY, so the USD notional is 100 USD, and the JPY notional is 11,000 JPY.
Note that the ratio of notionals is exactly the strike, and thus if you move the strike, you must change one or the other notional. For instance, if you move the strike to 100, then if you hold the USD fixed at 100, the JPY notional becomes 10,000: you will pay the same number of USD, and receive fewer JPY. Alternatively, you could hold JPY constant at 11,000 and change the USD notional to 110: you pay more USD and receive the same number of JPY (you've changed the price of JPY, denominated in USD).
When hedging a foreign currency exposure, (say for an American USD business, an outflow of 11,000 JPY) it is the foreign currency notional that must be fixed.
s track underlying positions, so an investment performs equivalently to purchasing that number of physical positions, though the fund may in fact not directly purchase the positions, and instead use derivatives (especially futures) to produce the position.
Levered ETFs, notably inverse exchange-traded fund
s, have the unusual property that their notional changes every day: this is because they pay the compounded daily return, so it is as if one were re-investing each day's earnings at the new daily price: if one has an inverse ETF in an asset that goes down, one has more money, which one uses to short a cheaper asset, hence one's unit notional goes up, and conversely if the asset has gone up in value. See inverse exchange-traded fund
for mathematical details.
Explanation
Contrast a bond with an interest rate swapInterest rate swap
An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
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- In a bond, the buyer pays the principal amount at issue (start), then receives coupons (computed off this principal) over the life of the bond, then receives the principal back at maturity (end).
- In a swap, no principal changes hands at inception (start) or expiry (end), and in the meantime, interest payments are computed based on a notional amount, which acts as if it were the principal amount of a bond, hence the term notional principal amount, abbreviated to notional.
In simple terms the notional principal amount is essentially how much of the asset or bonds a person has. For example, if a premium bond was bought for £1 then the notional principal amount would be £1. Hence the notional principal amount is the quantity of the assets and bonds.
Interest rate swaps
In the context of an interest rate swapInterest rate swap
An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
, the notional principal amount is the specified amount on which the exchanged interest payments are based; this could be 8000 US dollars, or 2,7 million pounds sterling, or any other combination of a number and a currency. Each period's rates are multiplied by the notional principal amount to determine the height and currency of each counter-party's payment. A notional principal amount is the amount used as a reference to calculate the amount of interest due on an 'interest only class' which is not entitled to any principal.
Total return swaps
In a typical total return swapTotal return swap
Total return swap, or TRS , or total rate of return swap, or TRORS, is a financial contract that transfers both the credit risk and market risk of an underlying asset.- Contract definition :...
, one party pays a fixed or floating rate multiplied by a notional principal amount plus the depreciation, if any, in a notional amount of property in exchange for payments by the other party of the appreciation, if any, on the same notional amount of property. For example, assume the underlying property is the S&P 500 stock index. A would pay B LIBOR times a $100 notional amount plus depreciation, if any, on a $100 notional investment in the S&P 500 index. B would pay A the appreciation, if any, in the same notional S&P 500 investment.
Equity options
Shares also have a notional principal amount but it is called nominal instead of notional.If you are buying stock option contracts, for example, those contracts could potentially give you a lot more shares than you could control by buying shares outright. So the Notional Value is the value of what you control rather than the value of what you own.
So for instance if you purchase 1 equity call option for a stock that is currently trading at $60 (with a strike of $60), then you have the same upside potential as someone who holds $6,000 of stock, but you may have paid only $5/option (for a total of $500), so by this measure you have achieved leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
of $6,000/$500 = 12x. Note that if the stock price moves to $70, your dollar notional is now $7,000 (- cost of option and commission differential), but your quantity (unit notional) is still 100 shares.
Foreign Currency/Exchange or "FX" derivatives
In FX derivatives, such as forwards or options, there are two notionals.Suppose you have a call option on USD/JPY struck at 110, and you buy one of these. Then this gives you the option to pay 100 USD and receive 110 x 100 = 11,000 JPY, so the USD notional is 100 USD, and the JPY notional is 11,000 JPY.
Note that the ratio of notionals is exactly the strike, and thus if you move the strike, you must change one or the other notional. For instance, if you move the strike to 100, then if you hold the USD fixed at 100, the JPY notional becomes 10,000: you will pay the same number of USD, and receive fewer JPY. Alternatively, you could hold JPY constant at 11,000 and change the USD notional to 110: you pay more USD and receive the same number of JPY (you've changed the price of JPY, denominated in USD).
When hedging a foreign currency exposure, (say for an American USD business, an outflow of 11,000 JPY) it is the foreign currency notional that must be fixed.
ETFs
Exchange-traded fundExchange-traded fund
An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
s track underlying positions, so an investment performs equivalently to purchasing that number of physical positions, though the fund may in fact not directly purchase the positions, and instead use derivatives (especially futures) to produce the position.
Levered ETFs, notably inverse exchange-traded fund
Inverse exchange-traded fund
An inverse exchange-traded fund is an exchange-traded fund , traded on a public stock market, which is designed to perform as the inverse of whatever index or benchmark it is designed to track...
s, have the unusual property that their notional changes every day: this is because they pay the compounded daily return, so it is as if one were re-investing each day's earnings at the new daily price: if one has an inverse ETF in an asset that goes down, one has more money, which one uses to short a cheaper asset, hence one's unit notional goes up, and conversely if the asset has gone up in value. See inverse exchange-traded fund
Inverse exchange-traded fund
An inverse exchange-traded fund is an exchange-traded fund , traded on a public stock market, which is designed to perform as the inverse of whatever index or benchmark it is designed to track...
for mathematical details.