What is “notional value”?
In my simple example, it is the billions of dollars in trades that occur every day for the 30 Dow stocks.
In a real derivative, such as a bank would actually sell to a customer, it is a little more complicated.
Let’s take a vanilla interest-rate swap. A bank customer wants to hedge against high interest rates. The customer agrees to pay the bank 4% on a notional principal of $100 million, and in turn the bank will pay the customer the LIBOR + 1% on the same notional principal. The contract is for a fixed term of years, and the amounts are netted with every monthly payment. So if the LIBOR is 2%, the respective rates are 3% and 4%, so the first month the customer pays the bank about $83,000. But suppose that next year, the LIBOR goes to 3%. The amounts due net out, so there is no payment. If, the year after that, the LIBOR goes to 4%, then the bank has to pay the customer $83,000 every month.
The important thing to note is that the notional principal, $100 million, does not exist and cannot be lost by either party. The customer might end up paying a couple million during the life of a four-year contract. The bank’s liability is theoretically unlimited, if interest rates rise dramatically.
The customer enters into this contract, presumably, because they would lose money in their business if interest rates rose. They transfer this risk to the bank, which is better able to manage it because they have (a) tons of money on their balance sheet, and (b) are in the business of managing risk. They may well make more money if interest rates go up, allowing them to pay the customer what the contract calls for.
I hope this helps.