Notional Value Meaning
The notional value of any financial instrument means the total value of the derivative contract it holds and calculated by multiplying the total number of units that are there in the contract with the spot price of the said units prevailing in the market.
An options contract consists of 100 underlying shares. The call option is trading for $1.80. The underlying shares are selling for $25 each. The call option is opted by the investor for $1,800 ($1.80 * 100 shares).
Calculation of Notional Value
- = 100 * $25
- = $2,500
Thus, the nominal value of the derivatives contract comes to be $2,500.
An index future contract consists of 50 units of the index. One unit of the index is selling for $1,000.
Calculation of Notional Value
- = 50 * $1,000
- = $50,000
Thus, the nominal value of the future index contract comes to be $50,000
Relevance and Uses
#1 – Interest Rate Swaps
An interest rate swapInterest Rate SwapAn interest rate swap is a deal between two parties on interest payments. The most common interest rate swap arrangement is when Party A agrees to make payments to Party B on a fixed interest rate, and Party B pays Party A on a floating interest rate. is a contract in which the parties agree to exchange future interest payments with each other. The calculation of interest is done on a notional principal amount, which is determined well in advance. The interest amounts are calculated by multiplying applicable interest rates with the notional principal amount. Thus, this value serves as a base for interest calculations.
#2 – Currency Swaps
The currency swap is a kind of contract in which the parties agree to exchange the principal amount as well as the interest payments in the future represented in separate currencies. As in the case of interest rate swaps, it helps in the calculation of interest payments on the pre-determined notional principal in currency swap contractsCurrency Swap ContractsCurrency Swap is an agreement between the two parties for exchanging notional amount in one currency with that of another currency. It's interest rate can be fixed or floating rates denominated in two currencies. .
#3 – Equity Options
In an equity option, a holder of the option gets the right to buy or sell the underlying security at the strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market. in the future, though he is not obligated to do so. The nominal value of the option represents the total value of the option that an investor holds.
Notional Value vs. Face Value
Notional value is the total value that a financial contract holds at the current spot priceSpot PriceA spot price is the current market price of a commodity, financial product, or derivative product, and it is the price at which an investor or trader can buy or sell an asset or security for immediate delivery.. It is calculated by considering the spot value of all the underlying assetsUnderlying AssetsUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. of a financial contract.
On the other hand, the face value of a security is the value set by the issuer of the said security. It is mentioned on the certificate of the security such as share certificate. All the interest payments are done based on face value and not based on notional value. Also, the face value of a particular security is fixed, but the notional value keeps on fluctuating based on market conditions.
Why is Notional Value Irrelevant?
It is just an imaginary figure and maybe irrelevant due to the below-mentioned reasons:
- It doesn’t take into account the risk that the parties to a financial contract bear.
- In the case of contracts relating to interest rate swaps, it is not the notional value that plays an important role. Instead, fluctuation in the LIBOR rate LIBOR RateLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions. acts as a real game-changer.
As explained in the article, the notional value of a financial instrument represents the total value that the underlying securities hold based on the spot price. The same is used in various kinds of derivative contracts such as interest-rate swaps, currency swaps, stock optionsStock OptionsStock options are derivative instruments that give the holder the right to buy or sell any stock at a predetermined price regardless of the prevailing market prices. It typically consists of four components: the strike price, the expiry date, the lot size, and the share premium., and so on.
This has been a guide to Notional Value and its Meaning. Here we discuss formula, examples, why the notional value is irrelevant along with its differences from face value. You can learn more about financing from the following articles –