What is Notional Value?
Notional values are most discussed in derivatives and transactions because those transactions often involve hedging, which means that a small amount of can influence a very large . The helps distinguish between the amount of money actually invested from the amount of money involved in the whole transaction.
How Does Notional Value Work?
Consider an interest rate 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 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 Does Notional Value Matter?
Notional value is the totalvalue of a hedged position.