Understanding Notional Value and How it Works
This article discusses the concept of Notional Value, how to compute Notional Value, and its applications. It also talks about how Notional Value differs from Market Value. Finally, it discusses the concept of effective Notional Value and why it is important for investors.
Notional Value (NV), or simply, Notional, refers to the value of the underlying asset in a derivative contract. NV is applicable to several investments including options, futures, currencies, as well as forward contracts. It is simply the face value of the underlying asset on which payments are based upon. NV can also refer to a position’s total value, how much value is controlled by the position, or the amount agreed-upon in a contract.
How to calculate Notional Value?
Two variables are required to calculate NV. These include Contract Size and Underlying Price. The formula for calculation is:
Notional Value = Contract Size x Underlying Price
What are the key differences between Market Value and Notional Value?
Notional Value or NV and Market Value or MV are two different concepts. While NV provides the total value of a position taken in a derivatives contract, MV is the price at which the position can be purchased or sold in the open market.
MV is prone to fluctuations depending on market movements, while NV, as the face value of the underlying asset, is fixed.
The NV of a position is usually higher than the MV. This is because of the leverage (debt undertaken) employed by the derivatives trader. A small investment allows the trader to control a vast position in the underlying asset due to the leverage employed. In contrast, MV is merely the market price at which the position can be bought or sold on the open market. NV divided by the MV provides us with the degree of leverage employed by the derivatives trader.
A derivatives trader must use the NV or Face Value and not the MV while hedging his or her exposure to an asset. For example, if an investor is long INR 10 crores in 10-year investment-grade bonds, the position’s Nominal Value or Face Value is INR 10 crores. This is the amount the investor would use in hedging the investment. The investor can purchase put options to hedge the exposure or to protect against rising interest rates which would diminish the market value of the investment.
Key applications of Notional Value
Knowing the NV of an asset is very useful to investors for several reasons. These include:
- Wide application: NV can be used to assess the value of several positions including futures, equity stocks, interest rate swaps, equity options, total return swaps, and foreign currency derivatives.
In interest rate swaps, the NV is used to compute interest payments between parties.
In terms of equity options, NV refers to the face value of the stock option controls. For example, if a trader purchases call options on 100 shares of Company Z, with a face value of INR 500 for each share, the notional value of the trader’s position is 500*100 = INR 50,000.
Foreign exchange derivatives could have two possible Nominal Values – one based on the primary currency and one based on the secondary currency. However, most trades take place with NV based on the primary currency.
- Determination of portfolio risk: An assessment of NV is integral in the assessment of portfolio risk. Derivative traders use NV in the determination of hedge ratios to counter portfolio risk. For example, if a trader has a position of INR2 lakh in the Indian equity market, they can use derivatives to hedge that risk using stock market futures contracts. If the notional value of each stock market future contract is INR 40,000, and the market value of each derivative contract is INR 5,000, the investor’s hedge ratio can be computed as:
Hedge Ratio (HR) = Cash Exposure Risk (CER) / Notional Value of Related Underlying Asset (NVRUA)
Or, in this case,
HR = 2,00,000 / 40,000 = 5
Hence, the trader needs to sell 5 stock market futures contracts to hedge his position in the stock market. In this case, the market-value of the position would be 5*5000 = INR 25,000
What is effective Notional Value?
Effective NV is the face value of the underlying asset reduced by the cost of entering the hedge used to minimize the position’s risk. For example, suppose a trader is long trading 100 shares of Company ABC with a face value of INR 500 each. Therefore, the NV for the trader’s position is 100*500 = INR 50,000. Now, to hedge the long position, suppose the trader purchases 100 out-of-the-money put options costing INR 5 each. The total cost of the premium for the put options is INR 5*100 = INR 500. After incorporating the cost of the hedge, the effective NV of the trader’s position works out to INR 50,000 – INR 5*100 = INR 49,500.
To conclude, Notional Value serves as the base or the face value for computing the value of the position taken by the investor. It also serves as the basis for computing the amount needed to be hedged by the investor. This makes NV an invaluable concept for entering and hedging derivative contracts.