Different financial instruments will have a face value. This is referred to as a notional amount or notional value. The word ‘notional’ means that something is just an idea and not a physical reality. The reason why we talk about a notional amount on a financial instrument is that it is an amount of money that doesn’t actually change hands. This numerical value is still important though, especially when it comes to calculating any payments that need to be made on a bond, future, or other derivative instrument.
How Notional Amount is Used in Practice
It can be a bit difficult to grasp the advantages of a notional amount upon first hearing about it. Many people invest in bonds and these can be a good choice for future financial security. Most bonds provide the holder with regular interest repayments and this is one of the great benefits of them. Without a notional amount on each of these bonds it would be quite hard to calculate the interest due. Not only does this make it easier to determine how much to pay the holder of the bond, but it also allows the holder to calculate how much the bond is going to be worth to them over time.
It isn’t just bonds that benefit from having a known principal amount (yet another way of saying notional value). It is also necessary for shares of stock, contracts, and equity options. Here the notional amount can sometimes be called the nominal amount. Again this figure can be used to help the seller and buyer of these financial instruments.
The situation when dealing with foreign currencies is quite interesting because there are actually two nominal amounts here to deal with. Each currency will have their own notional value and agreement will need to be reached as to how they are traded. This involves deciding which of the currencies is going to be used as the basis for trade. Having a notional value for a foreign currency is of great importance to companies who wish to deal with other countries. It allows them to calculate their future trades within the foreign currency. This nominal value is fixed and so isn’t constantly fluctuating like foreign exchanges.
Some Final Thoughts on Notional Amount
Notional value is a simple idea but it can be confusing. The fact that it is not an actual amount of money that changes hands is the main reason for this confusion. As we have seen though, it is a useful value to have on bonds and other financial instruments. It makes it easier for investors and those selling these products to calculate any money that needs to be paid. It is also of use when an individual is attempting to work out the worth of their portfolio. The figures may differ in reality, but the notional amount acts as a useful guide.
