- A Word On The Notional Value Of Derivatives

I wanted to put up a quick note to explain the role that ‘notional’ values play in calculating the risk inherent in a derivative. Whenever a writer is trying to scare people regarding the derivatives market, they start talking about notional values. But those amounts don’t mean anything in the way that most people think about investing. They’re really just a marker that exists for accounting purposes. No one will ever lose a trillion dollars on a trillion dollar notional derivative. It’s not how they work.

But the people who write those scary articles don’t always know that themselves. And very often are writing the story in the first place because they don’t know it. So let me give you a very simple (maybe just a hair over-simple) example to explain the principle:

When writers start talking derivatives, they’re usually talking about the swaps market, which is by far the largest derivative market. The most common derivative in that space is what’s called a plain vanilla interest rate swap. The way that derivative works is that it’s an exchange of cash flows between two parties. For our purposes, let’s use the example of one party paying a single floating rate payment in 12 months and the other paying a single fixed rate payment in 12 months. They agree on a starting point, and when the payment will be made etc. And for this example let’s set the ‘notional value’ of this swap at 1 billion dollars.

If the interest rate for the swap is 5% now and 5% in 12 months then the ‘loss’ for the bank involved would be zero. It doesn’t matter if the notional amount is a billion dollars or a trillion. It’s still a total loss of zero. But let’s take look at what happens if the interest rates change.

If for instance rates had moved from 5% to 5.1%, then one party would pay a fixed 5% on the notional amount, and the other would pay a floating rate of 5.1% on the same amount. That’s one party paying 50 million, and the other paying 51 million, generating a net difference of 1 million dollars. One party would call that a gain on their billion dollar swap, and the other would call it a loss. But that total loss has taken 12 months to accrue. Break that into a daily gain/loss and it’s a total daily exposure of $3,846 dollars per day.

That’s it. A little less than 4K daily exposure on a 1 Billion dollar swap. This is a dramatic simplification, but it does address the basic principle. The billion dollar notional is never paid and never even risked. But if you’re trying to scare somebody, it’s a lot more intimidating than talking about a 4K daily exposure.

Not all derivatives are as simple as the example above, in fact… really none of them are. But as you add complexity to the derivative, typically the notional amount bears less of a relationship to the risk involved – not more.

And the point of all this is, if you know that a derivative has a notional value of 1 billion or 1 trillion, or even 10 Trillion, you really don’t know anything about how much risk the bank who issued it is really taking.

My friend Kevin Williamson posted a little blurb in the corner about a risk transfer that Bank of America pulled, that got partly tangled up in this issue. It may yet be a very serious issue, I don’t know the details. But I would be VERY surprised to discover that it was anything like 75 Trillion dollars at risk. I find it more likely that bank of America is doing this simply to keep their ‘borrowing’ cost low, and that it doesn’t represent a crisis moment at all.

Kevin is my friend, and is a terrifyingly smart guy. But he'd be the first to tell you that he doesn't have a financial background and no one has ever taught him this stuff. Even his corner post was phrased in the form of a question. Besides, just because the capital at risk is probably lower than the Bloomberg article would lead you to believe, it may still be a quite serious issue both legally and politically. Like I said, I don't know.

As for the others talking about this... while I love the guys at Zerohedge, they have been known to blow things slightly out of proportion on the very rare occasion. And as for the folks at Bloomberg news who wrote the original piece... as far as I can tell they don’t know the first thing about finance. And that it was they who started this ball rolling does not change that view.

This may be very serious, but we would need much more information than what's in the Bloomberg article to determine that. At a glance, I’d be more likely to call it a gap in the writer’s knowledge being blown just a tad out of proportion.