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.