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 is used when describing 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 a concept called leverage.
Leverage allows one to use a small amount of money to theoretically control a much larger amount. So, 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 market place. The amount of leverage utilized 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 x 2,800). Therefore, $140,000 is the notional value of that underlying 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 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 utilize (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 US equity market 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 7 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.
- Notional value is a term often used to value the underlying asset in a derivatives trade.
- Notional value of derivatives contracts is much higher than the market value due to a concept called leverage.
- Notional value is integral in assessing portfolio risk, which can be very useful when determining hedge ratios to offset that risk.
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.
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.