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]

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 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 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.

Examples

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.

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.

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 of $6,000/$500 = 12x.^[3] 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 funds 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 funds, 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.

Notes

1. ^ Notional amount – Definition from Investor Dictionary – Define meaning of the word Notional amount
2. ^ Sold at par.
3. ^ A different measure of leverage would be your Delta.

• To debit or credit on a daily basis a margin account based on the close of that day’s trading session. In this way, buyers and sellers are protected against the possibility of contract default.

• Describes the daily settlement of obligations on futures positions.

• To calculate the value of a financial instrument or portfolio of instruments based on the current market rates or prices of the underlying asset.

• In the futures market at the end of each trading day, the margin account is adjusted to reflect the investers’s gain or loss depending opon the futures closing price. This is called marking-to-market

• Valuing a marketable asset at its current market price.

• Fair value, also called fair price (in a commonplace conflation of the two distinct concepts), is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset, taking into account such objective factors as: * …

• When the market price of an option is in line with its theoretical value as predicted by a formula such as Black-Scholes.

• the value of the shares immediately before the effectuation of the corporate action to which the shareholder objects using customary and current valuation concepts and techniques generally employed for similar businesses in the context of the transaction requiring appraisal, and without …

• A mathematical relationship between the futures and the S&P 500 index.

• A term used to describe the worth of an option or futures contract as determined by a mathematical model.

• In the context of futures, the equilibrium price for futures contracts. Also called the theoretical futures price, which equals the spot price continuously compounded at the cost of carry rate for some time interval. …

• The amount that could reasonably be expected to be received for an investment in a current sale between a willing buyer and a willing seller. For publicly traded securities, this is the price at which the security is currently being traded on a national market. …

• Current value of the underlying shares or index, plus an amount referred to as the ‘cost of carry’. An estimate of the price an option should sell at in an efficient market.

• A stock’s real value. Based a user’s own criteria.

• Generally accepted accounting principles define fair value as the amount at which the asset could be sold in a current transaction between willing parties, other than in a forced or liquidation sale.

• a financial reporting principle for valuing assets and liabilities, for example, portfolio companies in venture capital fund portfolios. …

• The current value. For assets or liabilities for which there is an active market, this is generally the market value.

• evaluation of what could be defined as equitable “market” value in compliance with international accounting principles IAS/IFRS.

• The market value for which an investment could be exchanged in an arm’s length transaction. CapMan values investments to fair value in accordance with the guidelines of EVCA .

• The price of a financial instrument that a buyer would be willing to pay and a seller would be willing to accept on the open market. …

• A mathematically calculated value for an option or future that accommodates a trader’s parameters for interest rates, dividends etc. Different tax regimes or interest rate environments may give rise to different fair values for different investors in the same instrument.

• term used in federal and provincial corporation and securities statutes for the purpose of dissenting shareholder rights; also, defined as fair market value without consideration of minority discount.

• The amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm‘s length transaction.

• The theoretical value of an asset.

Risk inherent to the entire market of segment of market

The risk of price change dure to unique cricumstances of percific securities as opposed to the overall market.

This risk can be virtually eliminated from a portfollio through dirvesification… also called un systematic risk

Shh…!!!

I am very sofisticated mathematically. So, I would think that I would not have any issues understanding reading business analytics such as Value at Risk (VaR) articles. How wrong could I be!.

The difficulty is not in the mathematics itself; it is about learning the strange language people doing and using business analytics use.  Here under “business language” catagory is the alien language business analytics people use on a daily basis.