What Is Notional Value: Meaning, Formula, Uses And Importance

What Is Notional Value: Meaning, Formula, Uses And Importance

In derivatives markets, notional value is a term that trading firms use to indicate the overall market value of an asset. It can be the overall worth of a position, the quantity of value that a position controls, or a predetermined sum specified in a contract. To sum it up, the payment of a financial asset is determined by its face value. This term shall be used when describing derivatives contracts in options, futures, forwards, and currencies.

For a better and more detailed understanding of notional value, read ahead to explore notional value meaning, notional value formula, and definition.

Notional Value Meaning

The notional value definition says it is the face or total value of a position in a financial instrument, such as a derivative contract, is notional value. It helps differentiate between the full value of a trade from the share market value or the price of taking the trade.

Due to the leverage used, notional values for derivative contracts are significantly higher than the market value. In assessing the risk to a portfolio, notional value is an essential element and can be very useful for establishing a hedge ratio that mitigates that risk. Interest rate swaps, total return swaps, equity options, and foreign currency derivatives may be subject to notional values.

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Table of Content

  1. Notional Value Meaning
  2. Formula Of Notional Value
  3. Uses Of Notional Value
  4. Importance Of Notional Value
  5. Conclusion

Formula Of Notional Value

The following shall be used for the calculation of the notional value:

NV=CS×UP 

Where: 

  • NV=Notional Value 
  • CS=Contract Size 
  • UP=Underlying Price

Due to leverage and the use of borrowing money, the implied value of derivatives contracts is much larger than that found in the market. Leverage allows a man to use small amounts of cash and theoretically be able to control much more. Using the formula of notional value divided by market value, we can calculate the leverage used.

L=NV÷MV 

Where: 

  • L=Leverage 
  • NV=Notional Value 
  • MV=Market Value

Uses Of Notional Value

Several uses of notional value are listed below;

1. Currency Swaps

The type of interest rate swaps where counterparties swap principal and interest payments in several currencies can be regarded as currency swaps. The calculation of interest rate payments for currency swaps is, in the same way as with interest rate swaps, carried out on a fixed and predetermined intrinsic principal value. You should be aware of the fact that currency swaps involve two nominal values that are denominated in a variety of currencies. Unlike interest rate swaps, a currency swap also involves exchanging intrinsic principal values.

2. Interest Rate Swaps

Interest rate swaps are contracts in which counterparties agree to exchange future interest payments. Interest payments shall be calculated following the fixed notional principal value. The notional value can be denominated in any currency and taken at any weight. The cost of the due interest rate shall be calculated periodically, i.e., by multiplying the relevant interest rates by the notional principal amount. For example, the essential value of interest rate swaps is a simple theoretical value that can only be used to calculate interest payments.

3. Equity Options

The right to buy or sell the underlying shares at a specified price in the future is provided by equity options such as calls or puts, but it is not bound to trade the underlying shares at a fixed cost. In general, 100 shares are available to be purchased or sold in each of the options. The total value of an investor's position in a given chance is the nominal value of equity options.

4. Foreign Currency Exchange and Derivatives

Two possible notional values exist for foreign exchange futures: forwards and options. However, a notional value shall be quoted according to the common convention of the primary and secondary currency pairs for typical OTC foreign exchange derivative transactions.

Importance Of Notional Value

The notional value is the amount of the underlying asset that an investment manager may seek to hedge against. On the other hand, the market value will fluctuate over time based on market movements, which the investor is likely to seek to hedge, while the notional amount will remain the same.

Conclusion

The value of an underlying asset in a derivatives transaction shall be notional or face value. Therefore, if investors wish to hedge against a long position on ABC stock through options, they should consider buying puts to avoid downside movements. The notional value of the stock to be hedged by the investor shall determine the amount of the put.
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What is notional value FAQS?

The face or total value of a position in a financial instrument, such as a derivative contract, is notional value. This helps distinguish between the overall value of a trade and market prices or costs to obtain it.

The size of the contract in units is multiplied by its current price when calculating the notional value of a futures contract. The notional value helps understand and plan the risks of trading futures contracts.

In foreign exchange, the currency to be sold and bought is the notional amount, also known as the notional principal or the notional value. It is important to remember that there are always two notional values in foreign exchange since the currency swap will always involve two currencies.

The total amount of the underlying asset in respect of that security at its spot price shall count as notional value. The notional value is the amount of money put into a transaction and its associated amounts.

The nominal value of that security shall be referred to, in other words, as par or face value. The amount anticipated to pay on the security at maturity shall also be considered a nominal value. It's the price of redemption for security.