Notional ValueExplained with Journal Entry Examples
What Is Notional Value?
Notional value is the total value of the assets that are controlled in a derivative contract.
Notional value is also sometimes referred to as notional amount or notional principal amount.
This will be the overall value of any assets involved in this contract and will be based on whatever the underlying asset’s value is as well as the number of units that are part of the contract.
Notional value is frequently used when discussing derivative contracts that are in the currency, options, or futures markets.
Notional Value Explained
Notional value is the total net amount of a derivative transaction.
It can be calculated by taking the price of one of the units in the contract and multiplying this by the number of units of the underlying assets.
The formula for notional value is:
Notional value = Contract Size x Underlying Price
The notional amount of a derivative contract is higher than the market value of the contract due to leverage.
Leverage allows an investor to use a small amount of money to control a larger amount.
If an investor wants to use financial leverage ratios, they can divide the notional value by the market value.
Here is the formula.
Leverage = Notional Value / Market Value
Computing Notional Value
Derivative contracts have a variety of different multipliers, such as volumes or weights, among others, to describe what the contract’s underlying asset is.
As an example, suppose an investor bought a futures contract for wheat of 5,000 bushels.
The notional values of this contract was $60,000 ($12/ bushel * 5,000 bushels).
But, since the investor is using leverage, they will pay the market value instead of the notional value.
This means if the market price is $8.00/per bushel, they will pay $40,000 for the futures contract ($8/bushel * 5,000).
Therefore, the investor utilized 1.5 times leverage ($60,000 / $40,000.
Whether an investor is calculating the market value or notional value, they need to multiply the number of units in the contract by either the market price or notional price.
Uses of Notional Value
Notional value is useful in assessing the risk in a portfolio as well as for other things, such as interest rate swaps, equity options, and foreign currency derivatives, as well as other contracts that have an underlying asset price.
Notional value is useful for analysts and investors when assessing risk.
It is quite commonly used when analyzing risk in a portfolio.
Nominal value can be used to determine the hedge ratio needed to offset the portfolio’s risk as well.
Here is the formula an investor would use to use risk along with notional value to compute hedge ratios.
Hedge ratio = Cash exposure risk ÷ notional value of the related underlying asset
Interest Rate Swaps
For interest rate swaps, the notional value would be the specified value that would be used in determining the exchanged interest payments.
The counterparties would need to agree on the contract to exchange interest payments, which will be based on notional principal value.
Total Return Swaps
In a total return swap, one party pays a fixed or floating rate that is multiplied by a notional value amount and the decrease in notional value.
This payment is swapped for the payments that another party makes, which involve paying the appreciation of notional value.
In equity options, notional value is the value that is controlled by the option.
As an example, XYZ is trading for $50, and it has a certain XYZ call option that costs $5.00.
One of these equity options controls 500 underlying shares.
Suppose an investor purchased this option for $2,500 ($5.00 * 500).
The notional value of this option would be $25,000 ($50 * 500).
Therefore, by purchasing the stock option contract, the investor would potentially have control over 500 shares of stock for $2,500 rather than paying the market price of $25,000.
It is important to remember that notional value in the case of equity options is the value of the shares that the investor controls, not the transaction’s cost.
Foreign Currency Derivatives
Foreign exchange derivatives have two notional values.
Because two different currencies are involved in these transactions, both of the currencies have their own notional value.
- Notional value measures the value of the underlying asset in a derivatives contract.
- Notional value is often used in assessing portfolio risk. It can then be used to determine hedge ratios for offsetting the risk.
- The notional value of a derivatives contract will be higher than the market value because of leverage.
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