Explanation
Contrast aExamples
Interest rate swaps
In the context of an interest rate swap, the notional principal amount is the specified amount on which the exchanged interest payments are based; this could be 8000 US dollars, or 2.7 million pounds sterling, or any other combination of a number and a currency. Each period's rates are multiplied by the notional principal amount to determine the height and currency of each counter-party's payment. A notional principal amount is an amount used as a reference to calculate the amount of interest due on an 'interest only class' which is not entitled to any principal.Total return swaps
In a typical total return swap, one party pays a fixed or floating rate multiplied by a notional principal amount plus the depreciation, if any, in a notional amount of property, in exchange for payments by the other party of the appreciation, if any, on the same notional amount of property. For example, assume the underlying property is the S&P 500 stock index" A would pay B the London Inter-Bank Offered Rate, multiplied by a $100 notional amount plus depreciation, if any, on a $100 notional investment in the S&P 500 index. B would pay A the appreciation, if any, in the same notional S&P 500 investment.Equity options
Shares also have a notional principal amount, but it is called ''nominal'' instead of notional. For example, if stock option contracts are being bought, those contracts could potentially give a lot more shares than would be possible to control by buying shares outright. So the notional value is the value of what is controlled, rather than the value of what is owned. For instance, if a 100 share equity call option is purchased with a strike of $60 for a stock that is currently trading at $60, then it has the same upside potential as holding $6,000 of stock (1 option × 100 multiplier × $60), but the shares may have been purchased for $5 each (for a total of $500). By this measure, a leverage of $6,000/$500 = 12''x'' has been achieved.A different measure of leverage would be Delta. Note that if the stock price moves to $70, the dollar notional is now $7,000 (minus the cost of option and commission differential), but the quantity (unit notional) is still 1 contract.Foreign currency/exchange (FX derivatives)
In FX derivatives, such as forwards or options, there are ''two'' notionals. For example, if an individual has a call option on USD/JPY currency struck at 110, and one of these is purchased, then this gives the buyer the option to pay 100 USD and receive 110 × 100 = 11,000 JPY, so the USD notional is 100 USD, and the JPY notional is 11,000 JPY. Note that the ratio of notionals is exactly the strike, and thus if the strike is moved, one of the notionals will change. For instance, if the strike is moved to 100, and the USD fixed at 100, the JPY notional becomes 10,000; the buyer will pay the same number of USD and receive fewer JPY. Alternatively, JPY currency could be held constant at 11,000 and change the USD notional to 110: hence, the buyer will pay more in USD and receive the same number of JPY. When hedging foreign currency exposure, such as for an American business in USD, an outflow of 11,000 JPY, the ''foreign currency'' notional must be fixed.ETFs
Exchange-traded funds track underlying positions, so an investment performs equivalently to purchasing that number of physical positions, though the fund may in fact not directly purchase the positions, and instead use derivatives (especially futures) to produce the position. Levered ETFs, notablyNotes
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