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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 underlier100,000 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.
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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 billiontwenty times
that of the equivalent swap. |
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