What is a Notional Amount?
Also known as a notional value or a notional principal amount, a notional amount is the face value of a financial instrument. The amount is important, as it is necessary to accurately calculate any payments that must be made on that instrument. Because this amount does not actually change hands, it is referred to as being notional.
One of the easiest ways to understand how a notional amount is used in calculating payments is to consider the purchase of a bond issue. Assuming the bond is structured to pay interest to the holder at specific times throughout the life of the bond, it is important to know the face value. Without knowing this nominal amount, it is impossible to calculate the total of each interest payment as it comes due
Even in situations where the bond issue does not pay interest until the full maturity is reached, the notional amount is still vital to the process. Because the interest payment will be based on the total amount of the principle or face value of the bond, the figure is necessary in order to determine how much interest the holder is entitled to receive. From this perspective, the notional amount is also important to the holder, as it makes it much easier to project the amount of return that can reasonably be expected on the investment.
A notional amount is also important to calculating return on other types of investments, such as equity options, futures and forwards contracts, and shares of stock. In the case of stock, the notional amount is usually referred to as a nominal amount. This is because an investor may choose to engage in equity options as well as purchasing the shares outright. When this is the case, the nominal amount will focus on the number of shares involved in the equity call option rather than the number of shares actually purchased. This helps investors to leverage their earnings while still providing a principal figure to use in calculating return.
When entering into forwards or options as part of a currency exchange strategy, there are actually two notional amounts to consider. There is a nominal amount connected with each of the two currencies that are part of the exchange. Depending on exactly how the exchange strategy is implemented, one or the other amounts may serve as the basis for the trading activity. For example, if a domestic and a foreign currency are involved in the exchange, and the investor is choosing to hedge the exposure on the foreign currency, then the notional amount of the foreign currency is fixed and serves as the basis for calculating earnings generated by the exchange.
Written by Malcolm Tatum
