How is the return on notional principal calculated?

The return on notional principal is calculated by dividing the gain or loss on a derivative instrument by the notional principal. This approach is critical because it allows investors to assess the profitability or performance of a derivative relative to the amount that it represents or controls, which is captured by the notional principal.

The notional principal is essentially a reference amount used to calculate payments made on a derivative contract. By using the gain or loss in this context, it provides a clear understanding of how effectively the derivative is performing relative to the size of the investment that it represents. This method offers a measure of return that directly correlates to the exposure of the derivative position without requiring an actual cash outlay that corresponds to the notional amount.

In contrast, the other options do not accurately reflect how returns on notional principal should be calculated or do not apply to this specific context of derivatives. For instance, simply dividing total capital invested by total returns does not take into account the specific gains or losses tied to the notional amount. Averaging the returns over the investment period or comparing returns to market benchmarks may provide insights into investment performance but do not relate directly to the calculation of returns on notional principal in the framework of derivatives.