Definition: Notional value refers to the total net amount of a derivative transaction, usually an interest rate swap, a forward contract, a cross currency swap or an options contract.
What Does Notional Value Mean?
What is the definition of notional value? Notional value is different than the amount of money invested in a derivative contract. In fact, the notional amount is a reference value for calculating the interest on the transaction, and it expresses how much of the total value the derivative theoretically controls.
For instance, in an options contract of 100 shares of an underlying asset, the notional amount is the contract size (100) times the price of the underlying asset. So, if the option is purchased at $3 per share and the price of the underlying security is $24, the notional amount is $3 x 100 x $24 = $7,200.
Let’s look at an example.
Example
Alex owns a $100,000 investment at a monthly LIBOR of 2.25%. So, Alex receives $2,250 every month. If the LIBOR goes to 3%, Alex receives $3,000. If the LIBOR goes to 2%, Alex receives $2,000. Mary owns a $100,000 investment at a monthly fixed interest rate of 2.50%. So, regardless of the changes in the interest rates, Mary receives $2,500 every month.
Alex would prefer to have a fixed interest payment investment to be on the safe side, and Mary would prefer to have a floating interest rate to have a chance of receiving higher payments. So, what Alex and Mary can do is enter a fixed-for-floating swap and exchange interest rate cash flows.
The calculations of the interest rates are based on the notional amount of $100,000. So, Alex agrees to pay Mary LIBOR 2.25% per month in $100,000, and Mary agrees to pay Alex 2.50% per month in $100,000. After 12 months, Alex will have received $2,500 x 12 = $30,000 as interest payments, and Mary will have received $2,250 x 12 = $27,000. However, Mary has a potential of receiving higher payments if the LIBOR goes up, whereas Alex will have received a fixed payment of $2,500 per month.
Summary Definition
Define Notional Values: A notional amount means the value of all underlying assets of a security at the current price.
