What is Notional Value
Notional value is the total value of a position, how much value a position controls, or an agreed upon amount in a contract. This term is commonly used in the options, futures, and currency markets which employ the use of leverage, wherein a small amount of invested money can control a large position in the markets. Notional value helps distinguish the total value of a trade from the cost of taking the trade.
For example, one E-mini S&P 500 index future is $50 multiplied by the S&P 500 index. If someone buys a contract at 2,800, then that single futures contract is worth $140,000 ($50 x 2,800). Therefore, $140,000 is the notional value underlying that futures contract. The person buying this contract is not required to put up $140,000 when taking the trade, though. Rather, they only need to put up a fraction of this—called the initial margin—which could be $6,160 to $9,000 with many brokers (subject to change).
Breaking Down Notional Value
Notional value is the dollar amount an investor controls of a particular asset or position. It may be based on a market value, but there is a clear distinction: the notional value accounts for the total value of the position, while the market value is the price at which that position can be bought or sold in the market place.
While notional value can be used in futures and stocks (total value of the stock position), in the ways discussed above, notional value also applies to interest rate swaps, total return swaps, equity options, and foreign currency derivatives.
Interest Rate Swaps
In interest rate swaps, the notional value is the specified value upon which interest rates payments will be exchanged. The notional value in interest rate swaps is used to come up with the amount of interest due. Typically, the notional value on these types of contracts is fixed during the life of the contract.
Total Return Swaps
Total return swaps involve a party that pays a floating or fixed rate multiplied by a notional value amount plus the decrease in notional value. This is swapped for payments by another party that pays the appreciation of notional value.
Notional value in an option refers to the value that the option controls.
For example, ABC is trading for $20 with a particular ABC call option costing $1.50. One equity option controls 100 underlying shares. A trader purchases the option for $1.50 x 100 = $150.
The notional value of the option is $20 x 100 = $2,000. Buying the stock option contract would potentially give the trader control over a hundred shares of stock for $150 compared to if they purchased the stocks outright for $2,000.
The notional value of an equity options contract is the value of the shares that are controlled rather than the cost of the transaction.
Foreign Currency Exchange and Foreign Currency Derivatives
Foreign exchange derivatives like forwards and options have two notional values. Since these transactions involve two currencies, they both receive separate notional values. For example, if at the time of a trade the exchange rate between the British pound (GBP) and the US dollar (USD) is 1.5, then $1,000,000 USD is equivalent to 666,667 GBP.