Notional amount

Key takeaways

Notional amount belongs to science; place it in that map before memorising details.
Learn the definition first, then one example that makes the definition concrete.
Connect Notional amount to a quantity you can measure, compute or draw — that is where exam questions come from.
Reproduce the core statement of Notional amount from memory before moving on to harder problems.

Reference excerpt

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 and is thus referred to as notional.

Explanation Contrast a bond with an interest rate swap:

In a bond, 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 an asset or bonds a person owns. For example, if a premium bond were bought for £1, then the notional principal amount would be the face value amount of the premium bond that £1 was able to purchase. 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 could be 8000 US dollars, or 2.7 million pounds sterling, or any other combination of a number and a currency. Each period's rates are multiplied by the notional principal amount to determine the height and currency of each counter-party's payment. A notional principal amount is an 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 the London Inter-Bank Offered Rate, multiplied by 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. The notional amount refers to the total amount changing hand in case the option is exercised. Some people refer to it as nominal instead of notional. The formula is as follows: Notional amount = number of options * multiplier * strike price. The notional value is the value of what is controlled, rather than the value of what is owned. If stock option contracts are being bought, those contracts could potentially give a lot more shares than would be possible to control by buying shares outright. Let us assume we purchase 1 equity call option with a strike of USD 60. This option allows the holder to buy 100 shares (multiplier 100). In this case, the notional is USD 6'000. This position has the same upside potential as holding USD 6,000 of stock (1 option × 100 multiplier × USD 60), but the options may have been purchased for USD 5 each (for a total of USD 500). By this measure, a leverage of 6,000/500 = 12x has been achieved. Note that if the stock price moves to USD 70, the value of the shares that could be purchased is now USD 7,000 (minus the cost of option and commission differential), but the notional amount is still considered to be USD 6'000, the amount used to purchase 100 shares for USD 60 each.

Foreign currency/exchange (FX derivatives) In FX derivatives, such as forwards or options, there are two notionals. For example, if an individual has a call option on USD/JPY currency struck at 110, and one of these is purchased, then this gives the buyer the option to pay 100 USD and receive 110 × 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 the strike is moved, one of the notionals will change. For instance, if the strike is moved to 100, and the USD fixed at 100, the JPY notional becomes 10,000; the buyer will pay the same number of USD and receive fewer JPY. Alternatively, JPY currency could be held constant at 11,000 and change the USD notional to 110: hence, the buyer will pay more in USD and receive the same number of JPY. When hedging foreign currency exposure, such as for an American business in USD, an outflow of 11,000 JPY, the foreign currency notional 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; 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 an investor has an inverse ETF in an asset that goes down, they will have more money, which can be used to short a cheaper asset, hence one's unit notional goes up. Conversely, if the asset has gone up in value in this situation, the notional will go down, as seen in inverse exchange-traded funds,

Notes

External links https://support.help.minepi.com/wiki/spaces/WIKI/pages/33038#Welcome-to-the-official-Pi-Network-Community-Wiki!]

Worked examples

Example 1 — a first encounter with Notional amount

Start with the simplest possible case. Write down what Notional amount claims or describes in one sentence, then invent the smallest concrete situation in which that sentence is true. In science, the smallest case is usually a single object, a single equation or a single measurement. Check that every symbol or term in your sentence has a meaning in that case.

Example 2 — changing one variable

Take the situation from Example 1 and change exactly one quantity: double it, halve it, or set it to zero. Predict what should happen to Notional amount before you calculate. Comparing your prediction with the result is the fastest way to find out whether you understand the idea or only the words.

Example 3 — an exam-style question

Typical questions about Notional amount ask you to (a) state it precisely, (b) apply it to given data, and (c) explain a limitation. Practise writing all three answers in under five minutes; the third part is what separates a full-mark answer from an average one.

Applications of Notional amount

In research: Notional amount appears in science research whenever the underlying quantities have to be modelled precisely. Papers usually cite it as a starting assumption and then explore where it breaks down.
In technology and industry: Engineering practice reuses Notional amount in design rules, simulations and safety margins. Knowing the idea lets you read a specification sheet and understand why the numbers look the way they do.
In the classroom: Notional amount is common in secondary-school and first-year university syllabi. It links to neighbouring topics Derivatives (finance), Interest rates, Swaps (finance), so understanding it makes those chapters shorter.
In everyday life: Look for Notional amount outside the textbook — in sport, cooking, traffic, electronics or the sky above you. An example you found yourself is remembered far longer than one you were given.

How to study Notional amount in 20 minutes

Read the reference excerpt below once, without taking notes.
Close the page and write down what Notional amount means in your own words.
Compare your version with the excerpt and mark what you missed.
Work through the three examples above with pen and paper.
Explain Notional amount out loud to somebody else — or to Teacher Smith in the lgStudy chat.

Frequently asked questions

What is Notional amount in simple terms?

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 and is thus referred to as notional.

Why does Notional amount matter?

Because it connects several science ideas at once: it gives you a definition you can apply, a quantity you can calculate, and a way to check whether a result is plausible.

How should I study Notional amount?

Read the excerpt, restate it from memory, then work through the examples and applications listed on this page. The five-step study plan above takes about twenty minutes.

What does this page cover?

It gives you a compact reference excerpt plus original lgStudy explanations, examples, applications and study material on Notional amount.