Notional Amount is an important idea to understand when discussing derivatives. While all derivatives contracts have a notional amount, rarely does this sum ever actually change hands. Generally, contracts such as interest rate swaps involve exchanging cash flows based on a chosen reference price, but the total payments never come close to equaling this notional amount. Of course there are some contracts for which the notional amount might be exchanged, but these are far rarer.
Q. So I hear you were sitting with Alan Binder at the WHCA Dinner the other night, and he was saying that the size of the derivates market isn’t quite as scary as it sounds – – at $700T – – because that’s just the “notional”. What did he mean?
A. Let’s take an interest rate swap as an example. In one of those, you’re paying me a fixed rate, say 6%, and I’m paying you floating, maybe LIBOR plus 2%. But those amounts have to be computed against some reference number, of course. Let’s say that’s 1mm, so you’re paying me 60k year, and I’m maybe paying you somewhere around 40k. The notional—the reference amount—is $1mm; but the actual amounts at risk are much less.
Q. OK. So the notional amount itself is never paid in that example.
A. Right. It’s just the reference amount against which the interest flows are calculated.
Q. So how does it work in other derviates?
A. Here’s one that’s a bit trickier. In a “total return swap”, you’re really buying a position from me, say a $1mm Spanish Government Bond. So I pay you the interest I receive on the reference asset, plus any appreciation I may get on it. You usually pay me something like LIBOR and a spread, but also the depreciation on the bond. This transfers both credit and market risk on the asset to you.
Q. So there, the notional amount probably won’t turn into an obligation, but it could.
A. Right. If Spain blows up and defaults, you owe me the notional amount. So that’s why it’s tricky to say how much of the $700 T notional derivates market really are amounts at risk. Interest rate swaps, where the notional is not usually at risk, dominate the market; but there are lots of other kinds of derivatives where the notional can be in play.
Q. But, we don’t actually know the answer to that because these contracts are, for now, all over the counter and not traded on exchanges or cleared, right?
A. Exactly correct, although Dodd-Frank will change that to some degree. Meantime, it’s a guess. Binder guessed maybe 5% of the notional is at risk… but even so, that’s some number approximately equal to two times the entire US GDP. So its hardly a trivial market, no matter how you count.