Notional Value

What Is Notional Value?

The total value of the underlying asset in a contract is referred to as notional value, a term that derivatives traders frequently use. It may refer to the entire worth of a position, the quantity of value that a position controls, or a sum that is specified in a contract. To put it simply, payments on a financial asset are determined by its face value. Derivative contracts in the currency, options, futures, and forwards markets are referred to by this name.

How Notional Value Works

Without specifying the precise amount of money exchanged to enter a particular position, notional value in the derivatives markets indicates the scope or magnitude of a position. 

The notional amount of a futures contract is calculated by multiplying the contract price by the number of units of the underlying asset. For instance, the notional amount of a futures contract for 1,000 barrels of oil at ₹60 per barrel would be ₹60,000.

The market price of the underlying asset times the agreed-upon amount in an options transaction is the notional amount. The notional amount would be ₹5,000 if one option contract represented 100 shares of a stock trading at ₹50.

In swaps, interest rate payments based on a notional principle amount may be exchanged between two parties. Interest rate payments are computed using this amount as a reference. Still, the notional principal is usually not transferred.
 

How Notional Value is calculated?

The environment in which it is employed determines how to calculate the notional value. Here are two typical situations in which notional value is determined:

1. With regard to contracts including derivatives: Contracts for futures: A futures contract's notional value is determined by multiplying the contract size by the underlying asset's current market price. For instance, the notional value would be₹ 5,000 if you had a futures contract for 100 barrels of oil and the current market price was₹ 50 a barrel.

Contracts for options: The value of the underlying asset that the option grants you the right to purchase (in the case of a call option) or sell (in the case of a put option) is known as the notional value of an options contract.

This is only the underlying asset's market price as of right now.

2. Regarding swaps: The stated principal amount used to compute the interest rate or cash flows in a swap is known as the notional value. For instance, an interest rate swap with a₹ 1 million notional value indicates that interest payments are computed using this amount, but there is no actual principle exchange.

It is crucial to remember that notional value is merely a theoretical idea and does not correspond to an asset's or contract's actual cash flow or market value. In the financial markets, it is employed for computations and risk evaluation. 

Notional Value Example

Let's have a look at an interest rate swap agreement between two parties, wherein Party B agrees to pay Party A a variable interest rate on the same notional principle amount of₹ 1,000,000 and Party A agrees to pay Party B a fixed interest rate.

In this instance:

A₹ 1,000,000 notional value is involved.

It does not entail the actual exchange of the principal amount; rather, it indicates the amount utilized to compute interest payments.

Instead of exchanging the actual₹ 1,000,000, both parties agree to make payments based on the interest rates applied to this notional value.

Therefore, in an interest rate swap, cash flows can be calculated using the notional value as a reference point without exchanging the actual primary.
 

Notional Amount Uses in Swaps, Options, and Foreign Currencies

1. Uses in Interest Rate Swaps: In an interest rate swap, future interest payments are exchanged between counterparties. The predetermined notional principle value serves as the basis for calculating the interest payments. Any currency can be used to represent the notional value, and it can have any value.

The relevant interest rates are multiplied by the notional principal value to determine the periodic payable interest rate payments. In interest rate swaps, the notional principle value is, strictly speaking, a theoretical value used only in the interest payment computation.

2. Uses in Currency Swaps: A sort of interest rate swap in which the counterparties exchange principle and interest payments expressed in various currencies (e.g., US dollar vs. British pound) is known as a currency swap.
Interest rate payments for currency swaps are calculated using predefined notional principal values, just like interest rate swaps.

Keep in mind that currency swaps entail two notional values with two distinct currency values. Currency swaps, in contrast to interest rate swaps, also entail the exchange of notional principal values.

3. Uses with Stock Options Equity options, like calls and puts, provide you the option—but not the obligation—to purchase or sell the underlying shares at a given price at a later date. Typically, every option offers the chance to purchase or sell 100 shares. The overall value of an investor's position in options is their nominal value.

Put another way, the number of underlying shares multiplied by the share strike price yields the nominal value of the option.

For instance, a call option with a nominal value of ₹1,500 (₹15 x 100) would grant its holder the right to acquire 100 underlying shares at a price of ₹15 each.
 

Applications of Notional Value

Investors might benefit greatly from knowing an asset's net value (NV) for a number of reasons. Among them are:

1. Broad use: A variety of positions, like as futures, equity stocks, interest rate swaps, equity options, total return swaps, and foreign exchange derivatives, can be valued using NV. 

The NV is used to calculate interest payments between parties in interest rate swaps. 

NV refers to the face value of the stock option controls while discussing equity options. For instance, the notional value of a trader's position is 500*100 = ₹ 50,000 if the trader buys call options on 100 shares of Company Z, with a face value of ₹ 500 per share.

Two potential Nominal Values for foreign exchange derivatives are based on the primary and secondary currencies, respectively. On the basis of the main currency, NV is used in the majority of trades.  

2. Assessing the risk of a portfolio: An evaluation of NV is essential to determining portfolio risk. To mitigate portfolio risk, derivative traders use NV to calculate hedge ratios. For instance, a trader can utilize derivatives to employ stock market futures contracts to hedge the risk associated with a position of ₹ 2 lakh in the Indian equity market.

The investor's hedge ratio can be calculated as follows if the market value of each derivative contract is ₹ 5,000 and the notional value of each stock market future contract is ₹ 40,000.

Cash Exposure Risk (CER) / Notional Value of Related Underlying Asset (NVRUA) equals the hedge ratio (HR).
Otherwise, HR = 2,00,000 / 40,000 = 5 in this instance

Therefore, in order to hedge his stock market position, the trader must sell five stock market futures contracts. The market value of the position in this instance would be 5*5000 = ₹ 25,000.    
 

What is effective Notional Value?

The face value of the underlying asset less the expense of entering the hedge used to lower the position's risk is the effective net value, or NV. Let's take an example where a trader is long 100 shares of Company ABC, each of which has a face value of ₹ 500. The trader's position's NV is therefore 100*500 = ₹ 50,000. Let's say the trader buys 100 out-of-the-money put options at a cost of ₹ 5 per in order to hedge the long position. ₹ 5*100 = ₹ 500 is the total premium cost for the put options. The effective net value (NV) of the trader's position is ₹ 50,000 - ₹ 5*100 = ₹ 49,500 after deducting the cost of the hedge.    

Conclusion

When determining the worth of an investor's position, Notional worth is used as the foundation or face value. It also forms the foundation for determining how much the investor needs to hedge. Because of this, NV is a very useful idea when entering and hedging derivative contracts.