Investopedia: What is 'Notional Value'?

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Notional Value
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What is 'Notional Value'

Notional value is the total value of a leveraged position's assets. This term is commonly used in the options, futures and currency markets which employ the use of leverage, wherein a small amount of invested money can control a large position in the markets.

For example, one S&P 500 index futures contract obligates the buyer to 250 units of the S&P 500 index. If the index is trading at $1,000, then the single futures contract is similar to investing $250,000 (250 x $1,000). Therefore, $250,000 is the notional value underlying the futures contract.
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BREAKING DOWN 'Notional Value'

The notional value is essentially how much of a particular asset an investor has. It is often mixed with market value but there is a clear distinction: The notional value and market value both describe the amount of a security. The notional value accounts for the total number of forwards, options, foreign exchange currencies and futures, while the market value is the price of a security that can be bought or sold in the market.

Notional value may be seen and used in five ways: through interest rate swaps, total return swaps, equity options, foreign currency exchange derivatives and exchange-traded funds (ETFs).
Interest Rate Swaps

In interest rate swaps, the notional value is the specified value on which exchanged interest payments are based on. The notional value in interest rate swaps is used to come up with the amount of interest due for an interest-only class.
Total Return Swaps

Total return swaps involve a party that pays a floating or fixed rate multiplied by a notional value amount plus the decrease in notional value amount of property. This is swapped for payments by another party that pays the appreciation of notional value amount of the involved property.
Equity Options

Shares of stock also involve notional values. Instead of the term "notional," it is coined as "nominal."

For example, ABC is trading for $20 with a call option of $1.50. One equity option has 100 underlying shares. A trader purchases the option for $1.50 x 100 = $150. The notional value of the option is $20 x 100 = $2,000. Buying the stock option contract would potentially give the trader control over a hundred shares of stock for $150 compared to if he purchased the stocks outright for $2,000. The notional value of an equity options contract is the value of shares that is controlled rather than the value that is owned. Note that the notional value changes as the stock price moves up or down.
Foreign Currency Exchange and Foreign Currency Derivatives

Foreign exchange derivatives like forwards and options have two notional values. Since these involve trading two currencies, they both receive separate notional values. Hedging foreign currency also involves having a fixed foreign currency notional value.
Exchange-Traded Funds

For investments to perform like another well-performing fund, exchange-traded funds track and follow other positions. Some ETFs do not directly buy the positions. Instead, they use derivatives such futures to create the position.

Inverse exchange-traded funds have the unique characteristic of having a different notional value daily. The reason behind this is the daily compounded return is paid making it reinvest its daily earnings.
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Notional Principal Amount
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The notional principal amount, in an interest rate swap, is the predetermined dollar amounts on which the exchanged interest payments are based. The notional principal never changes hands in the transaction, which is why it is considered notional, or theoretical. Neither party pays nor receives the notional principal amount at any time; only interest rate payments change hands.
BREAKING DOWN 'Notional Principal Amount'
For example, two companies might enter into an interest rate swap contract as follows: For three years, Company A pays Company B 5% interest per year on a notional principal amount of $10 million. For the same three years, Company B pays Company A the one-year LIBOR rate on the same notional principal amount of $10 million. This would be considered a plain vanilla interest rate swap because one party pays interest at a fixed rate on the notional principal amount and the other party pays interest at a floating rate on the same notional principal amount.

Notional principal refers to the assumed amount of principal involved in a financial transaction, even though it is functionally separated from the transaction. This can include the underlying principal in a debt security in interest rate swaps, as the rates are actual components in the transaction, but the principal is functionally fictitious.
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