Understanding Notional Value and How It Works

What Is Notional Value?

Notional value is a term often used to value the underlying asset in a derivatives trade. It can be the total value of a position, how much value a position controls, or an agreed-upon amount in a contract. This term, meaning the same thing as face value, is used when describing leveraged derivative contracts in the options, futures, and currency markets.

Understanding Notional Value

In market parlance, notional value is the total underlying amount of a derivatives trade. The notional value of derivative contracts is much higher than the market value due to leverage, or the use of borrowed money.

Leverage allows one to use a small amount of money to theoretically control a much larger amount. Notional value helps distinguish the total value of a trade from the cost (or market value) of taking the trade. 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 marketplace. The amount of leverage used can be calculated by dividing notional value by market value.

Leverage = Notional value ÷ market value

A contract has a unique, standardized size that can be based on factors such as weight, volume, or multiplier. For example, a single COMEX Gold futures contract unit (GC) is 100 troy ounces, and an E-mini S&P 500 Index futures contract has a $50 multiplier. The notional value of the former is 100 times the market price of gold, while the notional value of the latter is 50 times the market price of the S&P 500 Index.

Notional value = Contract size × underlying price

If someone buys an E-mini S&P 500 contract at 2,800, then that single futures contract is worth $140,000 ($50 × 2,800). Therefore, $140,000 is the notional value of that underlying futures contract. The person buying this contract isn’t required to put up $140,000 when taking the trade, though.

Rather, they only need to put up an amount called the initial margin (market value), which is usually a fraction of the notional amount. The leverage used would be the notional amount divided by the price of buying the contract. If the price (initial margin) for one contract was $10,000, then the trader was able to use (140,000 ÷ 10,000) 14 times leverage.

Notional value is integral in assessing portfolio risk, which can be very useful when determining hedge ratios to offset that risk. For example, a fund has a $1,000,000 long exposure to U.S. equity markets, and the fund manager wants to offset that risk using the E-mini S&P 500 futures contracts. They would have to sell an approximately equivalent amount of S&P 500 futures contracts to hedge their market exposure risk. Using the above example, the notional value of each E-mini S&P 500 futures contract is $140,000 and the market value is $10,000.

Hedge ratio = Cash exposure risk ÷ notional value of related underlying asset

Hedge ratio = $1,000,000 ÷ $140,000 = 7.14

So, the fund manager would sell approximately seven E-mini S&P 500 contracts to effectively hedge their long cash position against market risk. The market value (cost) would be $70,000.

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 rate 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.

Equity Options

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 × 100 = $150.

The notional value of the option is $20 × 100 = $2,000. Buying the stock option contract would potentially give the trader control over 100 shares of stock for $150 compared with if they purchased the stocks outright for $2,000.

Foreign Currency Exchange and Foreign Currency Derivatives

Foreign exchange (FX) derivatives, like forwards and options, have two potential notional values. However, for typical over-the-counter (OTC) trades in FX derivatives, the notional value will be in line with the common quoting convention of the currency pair (primary currency/secondary currency).

For example, if the trade is in GBP/USD (GBP as the primary currency), then the amount of, say, GBP 10,000,000 will commonly be the notional amount of the trade. As another example, if the trade is in USD/JPY, the notional value would be USD 10,000,000, using USD as the primary currency. If the trade were in AUD/NZD, the notional amount would be in AUD, and so on.

Depending on the circumstances, the initiating counterparty may seek to use the secondary currency as the notional amount instead. For example, an American fund manager wants to buy USD 10 million worth of U.K. stock, priced in GBP, when GBP/USD is currently trading at 1.3000. In this case, the notional amount would be USD 10 million, or GBP 7.692 million. It’s mostly a matter of convenience for the two counterparties to decide on when initiating a trade.

The Bottom Line

Notional value, or face value, is the value of an underlying asset in a derivatives trade. If an investor seeks to hedge against a long position in ABC stock via options, for instance, they may wish to buy a put to protect against downside movements. The amount of the put will be based on the notional value of the stock that the investor is seeking to hedge.

Notional value stays the same as long as it’s fully hedged, whereas market value is subject to market movements, with no downside protection as in the case above. Notional value serves as the baseline for measuring an investment and whatever hedges may be deployed to protect the underlying investment.