Notional Value: Derivatives Markets

People often say that the size of the derivative markets is exploding. It is over $700 trillion dollars a year now and when we put that number into perspective that is over the GDP of all the countries in the world combined in the last 20 years. How can the value of derivatives in one year be greater than the efforts of all human beings on the face of the planet for the past 20 years! It is possible because the statistic being used is called notional value or face value. In this article, we will explain the concept of notional value in detail:

The Notional Value Conundrum

The notional values of all derivative contracts open worldwide have undergone a lot of scrutiny. To understand why this is so, we must understand that the total value of all derivatives contracts outstanding in the world is more than the money supply of the world. To put it other words, the value of all the derivatives in the world, exceeds all the money in the world. Surely, this is an impossible scenario and can provide absurd interpretations.

For instance consider the fact that the gross domestic product of the world is $50 trillion whereas the notional value of all derivatives contracts outstanding is a whopping $700 trillion i.e. 14 times greater than the GDP of the world!

Also, the market capitalization of every major corporation in the world adds up to about $43 trillion. Once again the notional value of derivative contracts employed by these corporations to hedge their risks is several times their valuation i.e. $700 trillion

Let’s have a closer look at the concept of notional value of derivative contracts in the remainder of this article.

What is Notional Value ?

Notional value present in derivative contracts is an imaginary value. Under normal circumstances, this amount never changes hands. Hence, it is not a real value but instead a notional value. This may sound confusing. However, we can help clarify this with the help of an example.

Consider the case of a swap in the derivatives market. A swap is when the payments are exchanged between any two parties. Let’s say that one party assumes that they have a million dollar loan and have a fixed interest rate of 2% on it whereas there is another party which also has a million dollar loan. However, their interest rate is LIBOR+0.3%. Now, a swap allows the parties to exchange these interest payments.

Notice that the payments being swapped are interest payments and not the principal payment of a million dollars. Neither of these parties owes the money to any other parties. This is just an assumed value based on which the contract was drawn. Hence, this is just an imaginary value or notional value.

Why is Notional Value Irrelevant ?

In most cases, notional value is simply irrelevant. The reasons for the same are as follows:

• In the above example, it may appear like the contract value is actually of a million dollars. However, a million dollars in never actually going to change hands until the interest rates are raised to be 100%. Hence the nominal value doesn’t make much of a difference. It is a movement in LIBOR that can cause the real damage.

• The payments in the derivate markets are usually netted off against one another. Therefore even if the notional value of contracts such as futures and forwards is a million dollars, their true exposure to the underlying credit risk would be a small fraction of the value.

When Does Notional Value Become Relevant ?

There are some types of derivatives in which the notional value becomes relevant. For instance consider the case of a financial product called a credit default swap. The credit default swap is basically an insurance against debt that one does not necessarily own. For instance, if I make a series of premium payments to the bank which issues me the default swap, the bank would then have to pay me the notional value of the amount in case there is a default in the underlying debt.

Hence, in this case, the notional value of the underlying asset such as a bond would begin to matter since it will have to be paid off in full. Such derivatives are considered to be extremely dangerous. This is because they pose systemic risk. If there are humungous losses triggered as a result of these derivatives, then there is a chance that some of the institutions may go bankrupt and what started as a local crisis may quickly escalate to become a much bigger one.

It is precisely for this reason that risky derivative products like credit default swaps must be strictly regulated and the exposure to these products must be cut down.

Hence for the most part, the concept of notional value is irrelevant. However, in some extreme cases, the value can become extremely relevant.