Updated July 11, 2023
Definition of Notional Value
In general terms, Notional Value (NV) is the nominal value of the securities in the case of shares, debentures, etc. which is known as the face value of the securities and is treated as the minimum value of securities which generally does not change with change in market conditions or other factors whereas in derivative market NV is the total value of the position which is called the value of the underlying asset.
Explanation
Notional Value is the minimum value of securities which is known as a face value in the case of shares and debentures. NV differs from the Market value which generally changes with changes in market conditions and growth of the organization whereas face value remains the same. In the derivatives market NV is much higher than the market value due to a concept called leverage. In Derivatives, NV is the total value of the position whereas market value is the price at which the position can be traded in the market. Leverage is calculated as a NV divided by the market value. In derivatives, futures, and options it is based on the factors like weight, volume, and multiplier. It is used in assessing the risk in the case of portfolio management especially in dealing with high-risk securities. NV makes the difference between money invested and money associated with the transaction.
Example of Notional Value
Trader buys E mini S&P 500 contract at 2500 and value is $ 60. Calculate the NV of the Contract and also calculate the leverage if the initial margin is $ 15000.
Solution:
| A | Contract Size | 2500 |
| B | Price of Single asset/ Underlying Asset in contract | $60 |
| C | Notional Value = A * B | $150,000.00 |
| D | Initial Margin/ Current Market Price of Contract | $15,000 |
| E | Leverage = C / D | 10 |
Hence Notional Value = $ 1,50,000 and Leverage is 10 times.
Leverage and Notional Value
Leverage is the calculation of risk which helps to determine whether to use own funds or funds to be borrowed in case of investing funds. It is also referred to as the amount of debt that a firm or organization can use to finance the asset. Whereas NV is the value of the underlying asset which includes leverage. The formula for calculating leverage from NV is as under:
Leverage allows using a small amount of money so as to control the larger amount.
Where as
Market Value Is Leverage * Notional Value.
NV and Leverage concept is most probably used in interest rate swaps, total return swaps, equity options, derivatives, exchange-traded funds, etc. NV and Leverage concepts help in investment-related decisions in the currency market, commodity market, and derivative market.
Notional Value of Futures
In futures, NV is calculated as contract size multiplied by the price per unit, which is represented by the spot price. Notional Value of Future contract helps to determine the value of asset represented by the underlying future contract. In futures spot price is referred to as the current price of the commodity. The Formula for calculating NV for futures is
For Example, One barley contract is comprised of 4000 quintals per quintal price being $ 500 so the Value of a future contract in the case of barley is 4000 * $ 500 = $ 20,00,000 or 4000 quintal times the $ 500 spot price. Here NV of Underlying Asset i.e. Barley reveals the total value of the underlying asset or the commodity that is in the control of the future contract. NV is considered the key factor in managing risk. Hence it plays a major role in future contracts.
Uses of Notional Value
The uses of NV are as under:
- It is used to Value the underlying asset in the case of derivative contracts.
- Notional Value is also used in Interest rate swaps to exchange the future interest payments which are used by the counter parties.
- Notional Value is also used in Currency Swaps for payments in different currencies to control the risk of currency fluctuations.
- The notional Value concept is also used in equity options like call or put options in order to right in the sale or purchase of shares at price fixed under the contract irrespective of the market price at that time in the future.
Risk of Notional Value
Risk of Notional Value involves the risk of the contract price is more than the contracted price which leads to loss to the investor. So, the investor needs to take certain factors and take the calculated risk to reduce the future loss.
NV in future and derivative contracts depends upon various market factors, which are not under the control of the organization or the investors. Hence risk involved is high but it can be reduced to moderate by taking the appropriate decisions. Hence the investor takes into account the cost as well as the risk associated with the contract in order to achieve the maximum returns.
Conclusion
Notional Value is a case of Shares and Debentures is the nominal value of shares and debentures which is also called the face value. Whereas NV in the case of futures, options, and derivatives is referred to as the value of the underlying asset. NV is the contract size multiplied by the underlying price. In the case of derivatives and futures NV involves leverage which is known as a risk factor. NV in the case of portfolio management helps to understand the risk in the portfolio and the nature of risk. The NV is also used in interest rate swaps, currency swaps, equity options, etc. NV in the case of futures is the contract size multiplied by the spot price or the contract price. Leverage and NV are as interrelated as NV involves leverage. In the Derivative market notional value is different from the market value. NV is contracted value whereas market value is the value that is trading in the market.
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