Read this critique on Reddit this morning. Thought it was interesting.<p>Sharing here:<p>&quot;Ah, this misleading derivatives stuff again...
In two steps:
Firstly, I&#x27;ll use as an example something called an interest rate swap. If you have a loan with floating rate interest payments, then this lets you change that to a fixed interest rate of say 4%. As follows:<p>The lender requires you to pay floating rate interest. The swap is an agreement with a third party derivatives guy that you should receive a floating rate from him and pay fixed to him. So every month you will receive whatever the floating rate is from the derivatives guy, and pay a fixed rate to him - and the floating you receive pass on to the guy charging interest on the loan.
For example: the loan has a floating rate payment which at the moment is 4%, and you agree with the derivatives guy that you should pay him a fixed rate of 4% and will receive whatever the floating rate is. If the floating rate rises to 8%, then you pay the derivatives guy 4% and receive 8% and pass those 8% on to the lender. If the floating rate falls to 2%, you pay the derivatives guy 4% and receive 2% and pass those on to the lender.<p>But 4% of what? For the calculation to work, you need a monetary amount to calculate 4% of. That is the notional. You receive cash of the floating rate * the notional, and pay cash 4% * the notional. You need some way to translate the percent into actual cash payments and that happens through the notional.<p>If your loan is 10m, then the notional amount you want is probably 10m. If you only want half fixed half floating, then you can set the notional amount to 5m.
But the notional amount is just the basis used for calculation. It&#x27;s not &quot;money&quot;. It&#x27;s a figure plugged into a formula. The notional isn&#x27;t put into the bank and can&#x27;t be withdrawn from it, and at the end of the period of interest payments the notional isn&#x27;t there anymore because its only purpose was to calculate those interest payments.<p>If someone wanted to they could break that entire counting system by simply making a swap with a notional of 1 centillion dollars and deciding the payment isi equal to 5% * notional &#x2F; 1 centillion. If you wanted to swap 100m USD you would need 100m of these contracts for a notional of 100 million centillion dollars. The actual money changing hands is nowhere near the notional.<p>Secondly:
Sometimes people use derivatives for speculation. What they can do is enter a contract and then after prices change they enter the opposite contract.
For example: contracts for oil 6 months from now are $50 per barrel. Someone buys contracts for 50 million barrels. Then the price changes to $60 per barrel. He then sells contracts for 50 million barrels.<p>The only practical effect of this trade is that he receives a cash sum today. In 6 months nothing happens - they are automatically matched and offset.
In this case the notional amount would be the price of 50 million barrels of oil times 2.<p>Now, it&#x27;s possible to do this at high speed. So rather than wait until the next day, he enters a contract and then the opposite seconds or milliseconds from each other. As long as the buying and the selling is for the same amount, this could make for an arbitrarily high notional.<p>There are absolutely risks in derivatives. For example, what happens if one party loses enough money to go bankrupt and all the bonds they placed as security for that event isn&#x27;t enough to cover the loss. But the notional amount is not a good place to start to understand risks. Like, every type of derivative will have its own rules for how the notional translates into actual cash - e.g. for an oil contract it would be the full value of the oil, and for an interest rape swap it would just be the amount that&#x27;s multiplied by the percentage.<p>Not someone who works with this daily, but covered it quite well in studies.&quot;