Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Notional Value

What it is:

Notional values are most discussed in derivatives and currency transactions because those transactions often involve hedging, which means that a small amount of money can influence a very large investment. The term helps distinguish between the amount of money actually invested from the amount of money involved in the whole transaction.

How it works (Example):

Consider an interest rate swap, which is a contractual agreement between two parties to exchange interest payments. Let's assume Charlie owns a $1 million investment that pays him LIBOR + 1% every month. As LIBOR goes up and down, the payment Charlie receives changes. Now assume that Sandy owns a $1 million investment that pays her 1.5% every month. The payment she receives never changes.

Charlie decides that that he would rather lock in a constant payment and Sandy decides that she'd rather take a chance on receiving higher payments. So Charlie and Sandy agree to enter into an interest rate swap contract.

Under the terms of their contract, Charlie agrees to pay Sandy LIBOR + 1% per month on a $1 million principal amount. This is the notional value. Sandy agrees to pay Charlie 1.5% per month on the $1 million notional amount.

Why it Matters:

Notional value is the total asset value of a hedged position.