What is Notional Value in Share Market? Meaning & Formula

Published on October 13, 2023 | 8 min read

Key Takeaways

Notional value represents the value of the underlying asset or exposure represented by a derivative contract.
Traders can calculate the notional value of a futures contract by multiplying the contract size by the futures price.
Unlike market value, notional value represents the value of the underlying exposure rather than the price paid for the derivative contract.
It is used as a reference for assessing exposure, leverage and hedge sizes across different derivative positions.

Many traders enter the derivatives market by paying a modest margin, overlooking the substantial underlying asset value represented by the contract. This total underlying figure represents the notional value.

Market participants can better understand their financial exposure if they understand this baseline.

Notional value, often referred to as the notional amount, represents the value of the underlying asset or exposure represented by a derivative contract. In finance, the word ‘notional’ signifies nominal or theoretical. The notional amount is generally used as a reference for calculating payments, settlements or other obligations under a derivative contract. It does not necessarily represent the amount exchanged between counterparties.

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In the Indian equity and index derivatives space, notional value represents the value of the underlying exposure associated with a derivative contract. While an investor may deposit only a fraction of the contract's notional value as margin, the derivative agreement represents an underlying asset value that can be substantially higher. Notional value is used across various derivative instruments, including equity and index futures and options, currency derivatives and interest rate derivatives.

How to Calculate Notional Value

Calculating notional value for a futures contract is simple and requires two variables: the contract size and the futures contract price. Notional Value = Contract Size × Futures Contract Price

Consider this example from the Indian stock market. Suppose an investor enters one futures contract of Company XYZ: Standard lot size: 250 shares Current futures price of Company XYZ: ₹1,600 per share

Notional Value = 250 × ₹1,600 = ₹4,00,000

While the exchange may require an upfront margin of only ₹80,000 to enter the trade, the contract represents an underlying value of ₹4,00,000. A change in the underlying or futures price affects the value of the position, while the actual profit or loss depends on the contract and its price movement.

The example is illustrative. Actual lot sizes and margin requirements are specified by the exchange and can change over time.

Notional Value vs Market Value: Key Differences

While market participants encounter both terms regularly, notional value and market value describe different aspects of a derivative position:

Parameter	Notional Value	Market Value
Core Definition	The value of the underlying asset or exposure represented by the derivative contract.	The current value or price of the derivative contract in the market.
Nature	A reference measure used to assess underlying exposure and, depending on the derivative, calculate payments or settlement amounts.	The amount at which the derivative position is valued or traded in the market.
Magnitude	Can be substantially higher than the amount of capital or premium required to establish a derivative position.	Depends on the type of derivative. For an option, it is generally represented by the option premium multiplied by the contract size.
Price Movement	For futures, the notional value changes with the futures price. For options, the underlying notional amount is generally based on the contract's underlying quantity and price, while the option's market value is affected by factors such as the underlying price, time to expiry and volatility.	Changes according to the market price of the derivative and factors relevant to that instrument.

To see this difference in practice, consider a call option contract on an index with a lot size of 50 trading at a premium of ₹100. The option premium value is ₹5,000 (50 × ₹100). However, if the underlying index trades at ₹22,000, the underlying value represented by the contract is ₹11,00,000 (50 × ₹22,000). These figures represent different aspects of the option contract and should not be treated as interchangeable.

Why Notional Value Matters in Derivatives

Evaluating Financial Leverage: Leverage permits traders to control an exposure larger than the capital deployed. Dividing notional exposure by the capital deployed can provide a simplified measure of leverage: Leverage Ratio = Notional Value ÷ Capital or Margin Deployed

A higher ratio means that a given amount of capital is associated with a larger notional exposure. It does not, by itself, indicate the actual profit or loss on a position.

Designing Hedges: Institutional investors and portfolio managers may use notional value when determining the size of a derivatives position used for hedging. If an investor holds an equity portfolio worth ₹20,00,000 and wishes to hedge using index futures where one contract has a notional value of ₹10,00,000, a simple notional-value calculation gives two contracts:

Number of Futures Contracts = Portfolio Exposure ÷ Notional Value of One Futures Contract ₹20,00,000 ÷ ₹10,00,000 = 2 contracts

This is a simplified notional hedge calculation. The number of contracts required for an actual hedge can differ depending on factors such as the portfolio's relationship with the underlying index.

Administering Swaps and Foreign Exchange: In interest rate swaps and currency derivatives, the notional principal can serve as the reference amount used to calculate periodic interest payments or other settlement amounts. The full notional principal is not necessarily exchanged between counterparties.

What Is Effective Notional Value?

Effective notional value is not a single standard calculation applicable to all derivative positions. In some contexts, adjusted or effective notional exposure may be calculated after considering factors such as the position's delta or other risk adjustments. For example, an options position can be assessed using delta-adjusted notional exposure.

Delta measures how much an option's price is expected to change for a small change in the underlying asset's price, all else being equal. Therefore, multiplying the underlying notional value by the option's delta can provide a measure of delta-adjusted exposure. This is different from subtracting the option premium from the underlying notional value.

Key Applications of Notional Value Across Derivatives

Interest Rate and Currency Swaps

In swap agreements, notional value acts as the reference principal. Counterparties generally do not exchange this principal sum; instead, it serves as the benchmark to calculate periodic interest cash flows or other settlement amounts.

Equity and Index Options

For options contracts, notional value can represent the value of the underlying quantity associated with the contract. While an investor pays the option premium, the position represents an underlying exposure based on the contract's lot size and the underlying asset or index value. The option's market value, however, is determined by its premium and can change based on factors including the underlying price, time to expiry and volatility.

Foreign Exchange (Forex) Contracts

In currency forwards and futures, notional value denotes the value of the currency amount specified in the contract. This allows multinational institutions and other market participants to define the size of their foreign-exchange exposure and hedge positions without necessarily exchanging the full notional amount when the contract is initiated.

Conclusion

Notional value serves as an important reference measure in the derivatives market. While market value indicates the current value of the derivative position, notional value represents the value of the underlying exposure associated with the contract. Understanding the difference between these measures can help market participants assess the scale of a derivative position and interpret leverage and hedge calculations more accurately.

FAQs

Notional value is the value of the underlying asset or exposure represented by a derivative contract. It is generally calculated using the contract size and the relevant underlying or contract price.

How is notional value calculated?

For a futures contract, notional value can be calculated by multiplying the contract size by the futures contract price.

What is the difference between notional value and market value?

Notional value represents the value of the underlying exposure, while market value represents the current value or price of the derivative contract itself.

Why is notional value important in derivatives trading?

Notional value helps market participants understand the scale of their underlying exposure and is used in calculations related to leverage, hedging and settlement.

Is notional value the same as the amount invested?

No. Notional value represents the underlying exposure associated with a derivative. The capital, margin or premium required to establish a position can be different from its notional value.

Does notional value change with the market price?

Yes. The notional value can change as the relevant underlying or contract price changes, depending on the type of derivative.

About Author

Bidita Sen

Senior Editor

Bidita Sen has spent over a decade first understanding the complex language of finance, then translating it into something humans can actually read. After a career spent chasing market trends, she now prefers chasing ghosts. When she's not working, you’ll find her reading or re-watching the Paranormal Activity series. Because, real-life math is much scarier than a haunted house.