Notional Amount

Explained:

The notional amount for a future, option, or other derivative instrument that is settled with physical delivery is the quantity of the underlier to which the contract applies. A futures contract on 1000 bushels of corn has a notional amount of 1000 bushels.

Cash settled derivative instruments make payments according to contractually specified formulas. These depend upon some quantity of an underlier—100,000 barrels of oil, 500,000 USD, 100 shares of IBM stock, etc. That quantity is the notional amount.

For example, a cash settled call option on 100,000 barrels of crude oil has 100,000 barrels as its notional amount. An interest rate swap might entail two parties exchanging fixed-rate payments for floating rate payments linked to 6-month USD Libor, each based on a notional amount of USD 10MM.

Notional amount can give a crude sense of how leveraged a derivatives portfolio is, but this can be misleading. For example, a portfolio comprising a single USD 100MM 10-year swap has a total notional amount of USD 10MM. The same portfolio could be replicated with a strip of 20 FRAs with maturities spaced six month apart. Each FRA would have a notional amount of USD 100MM, so their combined notional amount would be USD 2 billion—twenty times that of the equivalent swap.

Related Internal Links

derivative instrument An instrument which derives its value from the value of other financial instruments. Article includes a list of vanilla and exotic derivatives.

par value A stated value for a security.

physical settlement, cash settlement Describes the two ways derivative instruments can settle.

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