Definition - What does Notional Value mean?
Notional value is the basis used for payments in currency markets and is used in forward contracts on securities and commodities, as well as option trading. It is also a common way of comparing investment options.
Calculation of the notional value involves determining the number of units covered by the transaction and multiplying the units by the applicable price for those units. In the case of a forward contract, this price is the spot price.
Notional value may also be called notional amount or notional principal amount.
Divestopedia explains Notional Value
In the case of a rate swap, the notional value is an arbitrary amount by which payment of interest is determined. For example, suppose that the notional value in an interest rate swap is $5 million and the two legs of the swap are at floating rate - perhaps LIBOR + 1% and a prefixed rate of 4%. In this deal, the interest rates are traded and the calculation is based on $5 million, which is the notional value of the deal.
We may use another example of a forward contract that involves 100 units of item A, commanding a spot price $5,000 each. The notional value is $500,000. Determining this notional amount helps investors to project the price after one month and enter into a forward transaction accordingly.
Notional value can help currency, commodity and equity traders arrive at a decision.