Notional amount

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The notional amount (or notional principal amount or notional value) 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.^[1]

1 Explanation
2 Examples
3 Notes
4 External links

[edit] Explanation

Contrast a bond with an interest rate swap:

In a bond,^[2] 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 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 I bought a premium bond for £1 then the notional principal amount would be £1. Hence the notional principal amount is the quantity of the assets and bonds.

[edit] Examples

[edit] Interest rate swaps

In the context of an interest rate swap, the notional principal amount is the specified amount on which the exchanged interest payments are based; this may be in US dollars, or pounds sterling, or whatever currency the swap is based on. Each period's rates are multiplied by the notional principal amount to determine the value 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.

[edit] Total return swaps

In a typical total return swap, 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.

[edit] 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 100 equity call options for a stock that is currently trading at $60 (with a strike of $75), 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.^[3] Note that if the stock price moves to $70, your dollar notional is now $7,000, but your quantity (unit notional) is still 100 shares.

[edit] 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 100 of these. Then this gives you the option to pay 100 USD and receive $110 \times 100 = 11,000$ 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.