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.
Examples
Example #1
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).
Solution
Calculation of Notional Value
- = 100 * $25
- = $2,500
Thus, the nominal value of the derivatives contract comes to be $2,500.
Example #2
An index future contract consists of 50 units of the index. One unit of the index is selling for $1,000.
Solution
Calculation of Notional Value
- = 50 * $1,000
- = $50,000
Thus, the nominal value of the future index contract comes to be $50,000
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Relevance and Uses
#1 – Interest Rate Swaps
An interest rate swap 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 contracts.
#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 price 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 price. It is calculated by considering the spot value of all the underlying assets 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 acts as a real game-changer.
Conclusion
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 options, and so on.
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