Notional Value

What Is Notional Value?

Any financial instrument's notional value (NV) represents the total underlying value of the derivative contract it references. It is determined by multiplying the total number of units in the contract by the current market spot price for the relevant units,

Due to leverage, the notional value of derivative contracts can be higher than the market value, as it theoretically allows a small amount of money to control a larger amount. As a result, it aids in distinguishing the total value of a trade from the cost (or market value) of the work.

There is a distinct difference: the market value is the price at which the position can be bought or sold in the market, whereas the notional value represents the total underlying value of the position.

Based on the spot price, a financial instrument's notional value represents the underlying securities' total value. Similar terms are employed in a variety of derivative contracts, including:

• Interest-rate swaps
• Currency swaps
• Stock options

The term 'notional value,' also known as 'notional amount,' is frequently used when valuing the underlying assets during derivatives trades spanning various financial instruments.

When referring to derivative contracts in the futures, options, and currency markets, the term "notional value" is frequently used. The notional value represents the total underlying amount in derivatives trading.

Notional Value Vs. Market Value

A security's worth can be expressed in terms of its market or notional value.

By way of debt obligations or derivatives contracts, for example, a security may theoretically represent a certain amount of total value, referred to as notional value.

On the other hand, market value is the price at which a security can currently be purchased or sold through a broker or an exchange.

Market value, which is calculated by dividing the number of outstanding shares by the current share price, is also used to describe the market capitalization of a publicly traded company.

Theoretically, a security's Notional Value represents the total underlying amount. It is typically greater than the market value.

Equity options and currency swaps both use Notional Value. The notional value determines the basis for interest rate payments in these instruments. Additionally, Notional Value helps assess portfolio risk.

The price at which securities can be bought and sold is called market value. It refers to a security's actual market value when it is purchased. Market value is also used to calculate a company's market capitalization. 

The market price of a share, or the current share price, is often multiplied by the number of outstanding shares to estimate this value, especially in the context of stocks.

For more clarity, let's check out the table below:

Uses in Swaps, Options, and Foreign Currencies

Notional value is important in various financial instruments, extending beyond stocks and futures to encompass interest rate swaps, total return swaps, equity options, and foreign currency derivatives.

Let's understand some of the different instruments wherein the notional value is used:

Interest Rate Swaps and Total Return Swaps

Interest rate swaps involve the exchange of future interest payments between counterparties, with calculations based on a predetermined notional principal value.

This theoretical value serves solely for interest payment calculations and can be denominated in any currency. On the other hand, total return swaps integrate both fixed or floating rates and changes in notional value, illustrating their dynamic nature.

Currency Swaps

Currency swaps, a variant of interest rate swaps, see counterparties exchanging principal and interest payments in different currencies.

Unlike interest rate swaps, currency swaps involve two notional values, each denominated in a different currency. Both types rely on predetermined notional principal values for calculating interest payments.

Equity Options

In equity options, such as calls or puts, notional value refers to the total value of the position an investor holds.

For instance, the nominal value of a call option can be determined by multiplying the number of underlying shares by the strike price. This gives investors a cost-effective way of controlling a larger stock position than outright stock purchases.

Foreign Currency Derivatives

In foreign exchange derivatives, notional values play a key role. When dealing with foreign currency through agreements like forwards and options, there's this idea of having two notional values. However, the rules in everyday trading (Over-The-Counter) match how currencies are usually quoted.

Imagine you're involved in a trade using Australian and Canadian dollars, represented as AUD/CAD. If the trade involves an amount of 5,000,000 Canadian dollars, that becomes the notional amount because CAD is the primary currency in this pair.

Now, if the situation is USD/AUD, where the U.S. dollar is the primary currency, and you're dealing with 8,000,000 Australian dollars, then the notional value switches to $8,000,000 to match the primary currency.

In some cases, let's say a European investor is interested in Australian assets and wants to use euros (EUR) as the notional currency. They might choose to express the notional value in euros, say €6,000,000, instead of using the Australian dollar amount directly.

This decision often depends on what's more practical or convenient for the parties involved in the trade.

Notional Value Examples

The following examples can help you better understand this concept, which can be tricky initially.

Example 1

When referring to an option's notional value, we mean its total underlying value. For instance, WSO currently trades at $20, and a specific WSO call option costs $1.50.

There are 100 underlying shares under one equity option. 

A trader pays for the option:

$1.50 x 100 = $150

The option's NV is

$20 x 100 = $2,000

Instead of paying $2,000 for 100 shares of stock outright, the trader could potentially control them for $150 by purchasing a stock option contract.

Instead of the price of the transaction, the notional value of an equity options contract is the total underlying value represented by the option.

Example 2

For instance, WSO currently trades at $70, and a specific WSO call option costs $2.

There are 100 underlying shares under one equity option. 

A trader pays for the option

$2 x 100 = $200

The option's NV is

$70 x 100 = $7,000

Instead of paying $7,000 for 100 shares of stock outright, the trader could potentially control them for $200 by purchasing a stock option contract.

Researched and authored by Drishti Kohli | LinkedIn

Reviewed and Edited by Aditya Salunke I LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Adjusted Present Value (APV)
• Enterprise Value (EV)
• Equity Value
• Net Present Value (NPV)
• Valuation Reserve