What is the Notional Value?
A term called “notional value,” is that is often employed to assess the value of the base asset in a derivatives trading. It could be the value of a position, the much value it controls or an agreed-upon amount in the contract. This term is commonly used to describe derivative contracts that are part of futures, options the futures as well as market for currencies.
Understanding the Notional Value
In the world of market terminology the term “notional value” refers to the sum of all the underlying value of a derivatives transaction. Notional values of derivatives contracts is significantly more than their market value because of the concept of leverage.
Leverage permits one to utilize an amount of money to theoretically control a larger sum. Therefore, the notional value can help identify the total value of a transaction from the value (or market value)of trading. It is clear in that the notional value accounts for the worth of the transaction and the market value represents the amount at which the position is bought or sold on the market. Leverage employed can be determined using the method of dividing notional value market value.
The leverage= Leverage of HTML1 =Notional value/market value
A contract is a distinctive size, standardized size that may be determined by factors like volume, weight or multiplier. For instance one COMEX gold futures (GC) unit (GC) comprises 100 troy troy ounces. In addition, the E-mini S&P 500 index futures contract includes a multiplier of $50. 1 2 The nominal value of the first will be 100 times market value of gold. The actual worth of the later is 50 times the value that is S&P 500 index. S&P 500 index.
Value of notionalis the value of a contract inContract size * price of the underlying
If someone purchases an E-mini S&P 500 contract for 2,800, that single contracts for futures will be worth 140,000 ($50 2800). This is therefore the theoretical value of that forward-looking futures contract. The buyer does not have to deposit $140,000 before making the purchase, however.
Instead, they require an amount known as”the first margin,(market value) which is typically an amount that is a fraction of the nominal amount. The leverage employed will be the notional value divided by the cost of purchasing the contract. If the cost (initial margin) for a single contract was $100,00, the trader was able make use of (140,000/10,000) 14x leverage.
The notion of notional value is essential in evaluating risk to portfolios. It is extremely useful in determining hedge ratios that can mitigate that risk. For instance the fund has a long exposure of $1,000,000 to the US equity market , and the fund manager would like to mitigate that risk by with an E-mini S&P 500 futures contracts. They will have to sell the equivalent number in S&P 500 contracts for futures in order to protect themselves from the risk of market exposure. In the above scenario the theoretical worth of an E-mini S&P 500 futures contract is $140,000 while the market value is $10,000.
Hedge rate= cash exposure risk or the notional value of an assets
Hedge ratio = $1,000,000 / $140,000 = 7.14
The fund manager would then sell around seven E-mini S&P 500 contracts in order to protect their cash position from market risk. The value of the market (cost) would be $70,000.
While notional value is utilized in stocks and futures (total worth of the position in stock) according to the methods discussed previously, notional value also is applicable to interest rate swaps or total return swaps, equity options, as well as derivatives of foreign currencies.
Interest Rate Swaps
When it comes to rates of swapping the notional amount is the value on the basis of which interest rate payment will be exchanged. The notional value of the interest rate swap is calculated to determine an amount for interest to be paid. Usually, the nominal value of these types of contracts is determined throughout the duration that the agreement.
Total Return Swaps
The total return swaps are when a party is liable for a fixed or floating rate multiplied by the notional value, and then the change in value. It is exchanged for payments from a third party, who is responsible for the increase in notional value.
Equity Options
The nominal value of the option is the amount that the option is able to control.
For instance, ABC is trading for $20, with a specific ABC call option that costs $1.50. One equity option is able to control 100 of the shares. A trader can purchase the option at $1.50 100 times $1.50 = $150.
The nominal worth of an option would be 20 per 100 = $2,000. The purchase of this options on stock contract could give the buyer control over a 100 shares at $150. This is in contrast to the case if they bought the stock in cash for $2,000.
The value that is notional for an equity option contract is the amount of the shares managed, not the price of the transaction.
Foreign Currency Exchange and Foreign Currency Derivatives
Foreign exchange derivatives, such as options, forwards and options carry two nominal value. Because these transactions are involving two currencies, they each have separate notional value. In the example above, if, when you make trading it is exchanged between British pounds (GBP) as well as USD US dollar (USD) is 1.5 1. is equivalent to 666,667 GBP.
