The term notional value refers to the value or spot price of an underlying asset in a derivatives trade, whether that's an option, futures, or a currency trade. This value helps perceive the difference between the total amount invested and the total amount associated with the entire transaction. The notional value is calculated by multiplying the units in one contract by the spot price.
Although both describe the value of a security, notional value is different from market value. Market value is generally used to describe the market capitalization of a publicly-traded company. It can also be used to describe the price an asset would go for in the open market. In order to get the market value, multiply the total number of outstanding shares by the current share price. But how do you calculate the notional value of a futures contract?
- The term notional value refers to the value or spot price of an underlying asset in a derivatives trade.
- The notional value calculation of a futures contract determines the value of the assets underlying the futures contract.
- To calculate the notional value of a futures contract, the contract size is multiplied by the price per unit of the commodity represented by the spot price.
- Notional value helps investors understand and plan for risk of loss.
Calculating a Future Contract's Notional Value
The notional value calculation of a futures contract determines the value of the assets underlying the futures contract. The spot price is the current price of the commodity. In order to do so, the size of the contract is multiplied by the price per unit of the commodity represented by the spot price.
Notional value = Contract size x Spot price
For example, one soybean contract is comprised of 5,000 bushels of soybeans. At a spot price of $9, the notional value of a soybean futures contract is $45,000, or 5,000 bushels times the $9 spot price.
Understanding the Notional Value Calculation
The notional value calculation reveals the total value of the underlying asset or commodity the contract controls. As with the soybean example, one soybean contract represents $45,000 of that asset. But that number is not the same as the option market value, which is how much the option contract currently trades on the market.
Option market value = Option price x Claim on underlying assets
If the soybean contract in the example above trades at $2, then the option market value would be $10,000—or the $2 option price times 5,000 bushels. The difference in notional value and option market value is due to the fact that options use leverage.
Why Notional Value Is Important
Notional value is key to managing risk. In particular, the notional value can be used to determine the hedge ratio, which lays out the number of contracts needed to hedge market risk. The hedge ratio calculation is:
Hedge ratio = Value at risk ÷ Notional value
Value at risk is the amount of an investor’s portfolio that is at risk—or subject to loss related to a particular market. For example, an investor has a $5 million position in soybeans that they would like to hedge against future losses. They’ll use a futures contract to do so.
Continuing with the soybean futures example from above, it would take roughly 111 of the above soybean futures contracts to hedge their position, or, $5 million divided by $45,000.
Notional value helps investors understand and plan for risk of loss. It may take a small amount of money to buy an option contract thanks to leverage, yet, movements in the underlying asset price can lead to a large swing in an investor’s account.
Notional value is key to managing risk, in that it helps investors understand and plan for risk of loss.
Futures Contracts and the Market
There are two main participants in the futures markets. Hedgers seek to manage their price risk for commodities, and speculators want to profit off of price fluctuations for commodities. Speculators provide a great deal of liquidity to the futures markets. Futures contracts allow speculators to take larger amounts of risk with less capital due to the high degree of leverage involved.
Futures contracts are financial derivatives with values based on an underlying asset. They are traded on centralized exchanges such as the Chicago Mercantile Exchange (CME) Group or the Intercontinental Exchange (ICE). The futures market began in the 1850s in Chicago with farmers seeking to hedge their crop production. Farmers could sell futures contracts to lock in a price for their crops. This allowed them to be unconcerned about daily price fluctuations of the spot price. The futures market has since expanded to include other commodities, such as energy futures, interest rate futures, and currency futures.
Unlike stocks that can exist in perpetuity, futures have an expiration date and are limited in their duration. The front-month futures contract is the contract with the nearest expiration date and is usually the closest in value to the spot price.
The price of the front-month futures contract may be substantially different than the contract a few months out. This allows the market to attempt to predict supply and demand for a commodity further out.