In a derivative, the ‘underlying’ and the ‘notional amount’ combine to determine the settlement amount of the instrument, that is the amount that one party will have to pay the other party in cash, stock or other consideration. The underlying is generally a referenced rate, index or measurable event. The notional amount may be a number of units (bushels or pounds for example), a number shares, a specified fixed dollar amount or some other unit of measure specified in the instrument. Typically, the settlement amount is determined by simply multiplying the underlying by the notional amount. For example, in the cashless settlement of a warrant, the settlement amount is determined by multiplying the number of shares (the notional amount) by the difference between the stock price (the underlying) and the warrant strike price. In other cases, the settlement formula may be more complex and introduce leverage or other factors that affect the final settlement amount.
As an alternative to a notional amount, some instruments may provide for a payment provision that specifies a fixed or determinable settlement to be made if the underlying behaves in a certain way. For example, the instrument may specify that a $1,000,000 payment is to be made in the event that the price of gold increases by $200. In this case, the underlying (the price of gold) alone drives settlement of the contract since there is no notional amount; however, the requirements of ASC 815-10-15-93 are met since movement of the underlying acts as an on-off switch in determining whether or not the payment provision is triggered.