What is notional value?
Notional value is a term often used to value the underlying asset in a derivatives business. It can be the total value of a position, the value controlled by a position or an amount agreed in a contract. This term is used to describe derivative contracts in the options, futures and currency markets.
Understanding the notional value
In market jargon, 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 you to use a small amount of money to theoretically control a much larger amount. Notional value thus makes it possible to distinguish the total value of a transaction from the cost (or market value) of taking the transaction. There is a clear distinction: the notional value represents the total value of the position, while the market value is the price at which this position can be bought or sold on the market. The amount of leverage used can be calculated by dividing the theoretical value by the market value.
Leverage = theoretical value ÷ market value
A contract has a single, standardized size which can be based on factors such as weight, volume or multiplier. For example, a single COMEX Gold Futures Unit (GC) is 100 troy ounces, and an E-mini S&P 500 Index Futures Contract has a multiplier of $ 50. The notional value of the first is 100 times the market price of gold while the notional value of the second is $ 50 the market price of the S&P 500 index.
Theoretical value = contract size * underlying price
If someone buys a 2,800 E-mini S&P 500 contract, that single futures contract is worth $ 140,000 ($ 50 x 2,800). Therefore, $ 140,000 is the face value of this underlying futures contract. However, the person purchasing this contract is not required to pay $ 140,000 during the transaction. Instead, they only need to set 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 purchase price of the contract. If the price (initial margin) of a contract was $ 10,000, the merchant was able to use (140,000 / 10,000) leverage 14 times.
Notional value is an integral part of assessing portfolio risk, which can be very useful in determining hedging ratios to compensate for this risk. For example, a fund has a long exposure of $ 1,000,000 to the US stock market and the fund manager wants to offset this risk by using the E-mini S&P 500 futures contracts. They should sell approximately the same amount of futures contracts S&P 500 to cover their risk of market exposure. Using the example above, the notional value of each E-mini S&P 500 futures contract is $ 140,000 and the market value is $ 10,000.
Coverage ratio = Risk of exposure to cash ÷ Notional value of the related underlying asset
Coverage ratio = $ 1,000,000 ÷ $ 140,000 = 7.14
Thus, the fund manager would sell around 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.
Although the notional value can be used in futures and stocks (total value of the equity position) as described above, the notional value also applies to interest rate swaps, swaps on total return, stock options and currency derivatives.
Key points to remember
- Notional value is a term often used to value the underlying asset in a derivatives business.
- The notional value of derivative contracts is much higher than the market value due to a concept called leverage.
- Notional value is an integral part of assessing portfolio risk, which can be very useful in determining hedging ratios to compensate for this risk.
Interest rate swaps
In interest rate swaps, the notional value is the specified value on which the interest rate payments will be exchanged. The notional value of interest rate swaps is used to calculate the amount of interest due. Generally, the notional value of these types of contracts is fixed for the duration of the contract.
Total return swaps
Total return swaps involve a party that pays a variable or fixed rate multiplied by an amount of notional value plus the decrease in notional value. This is exchanged for payments by another party who pays the appreciation in notional value.
The notional value of an option refers to the value that the option controls.
For example, ABC is trading at $ 20 with a specific ABC call option costing $ 1.50. A stock option controls 100 underlying stocks. A trader buys the option for $ 1.50 x 100 = $ 150.
The notional value of the option is $ 20 x 100 = $ 2,000. The purchase of the stock option contract would potentially give the trader control of a hundred shares for $ 150 compared to if they bought the shares for $ 2,000.
The notional value of a stock option contract is the value of the controlled shares rather than the cost of the transaction.
Exchange of foreign currencies and derivatives in foreign currencies
Currency derivatives such as futures and options have two theoretical values. Since these transactions involve two currencies, they both receive separate notional values. For example, if at the time of a transaction, the exchange rate between the British pound (GBP) and the US dollar (USD) is 1.5, then 1,000,000 USD corresponds to 666,667 GBP. (For a related reading, see “Comparison of notional value and market value”)