Notional Value: Everything You Need To Know

The world of finance provides a wide range of investment options along with several tools, techniques and concepts to potentially grow your wealth over time. One such concept is the notional value.

Whether you are exploring derivatives, options or futures, understanding what notional value means and how it works can help in making potentially more informed investment decisions.

In order to simplify notional value for you, this article breaks the concept down into several parts like its meaning, difference from market value, importance in trading, and the risks associated with it.

• Table of contents

• What is Notional value
• Difference between Notional value vs market value
• Example of Notional value
• Why Notional value is important in trading
• Risks of misunderstanding it

What is Notional value

Notional value, also called notional amount or notional principal, is the base amount used to calculate payments in financial contracts like swaps. In simple terms, it shows how much money is being controlled or represented by a position in financial security.

This value is commonly used in derivatives such as swaps, equity options, and futures. It helps show the full size (scale or exposure) of a contract, even though the actual money paid to enter the position is usually much less.

To illustrate with an example – in an interest rate swap, the interest payments are calculated based on the notional amount, although the principal itself is never exchanged.

Difference between Notional value vs market value

While it is true that both notional value and market value describe how much a security is worth, they describe it in different ways.

Notional value refers to the total amount of money a security or contract represents or controls, especially in cases like derivatives or loans. It’s more about the theoretical size of the position.

On the other hand, market value is the actual price you would pay or receive if you buy or sell the security right now. In the case of a company, market value (or market cap) is found by multiplying the total number of shares by the current share price.

Read Also: How Do Stock Market Crashes Impact Mutual Fund Investors

Example of Notional value

The market value of a financial contract is the price at which it is currently available in the market. For instance, let’s say a Nifty 50 futures contract is trading at Rs. 20,000. That means the market value of one unit of the Nifty 50 index is Rs 20,000.

Now, consider that one Nifty 50 futures contract consists of 75 units (also called lot size). In this case, the notional value of that single Nifty 50 futures contract would be:

Market Price × Lot Size = Notional Value

Rs. 20,000 × 75 = Rs. 15,00,000 (Rs.15 Lakhs)

So, while you may only need to pay a percentage of Rs. 15 lakh as margin to enter the trade, your exposure (or the total value being controlled) is Rs. 15 lakh as one Nifty 50 futures contract is leveraging 75 units of the index.

To elaborate some more: to enter a trade, an investor is typically required to deposit only a margin with the exchange, which is a fraction (usually 10–15%) of the notional value. Therefore, while you may only put up Rs. 1.5 – 2 lakh as margin, the total exposure is Rs. 15 lakh, and this is the notional value of the contract.

*Example for illustrative purposes only.

Why Notional value is important in trading

The notional value is the total value of the underlying asset. This amount is generally fixed throughout the life of the contract and can help determine leverage and potential risk exposure. On the other hand, the market value keeps changing with price movements in the market. Investors aim to mitigate the impact of market volatility by using derivatives.

Risks of misunderstanding it

Misunderstanding notional value can lead to potentially risky investment decisions. Investors might underestimate leverage, ignore margin needs, or misjudge the true size of their positions. This can result in them taking on more risk than their portfolio can handle, especially during volatile market conditions, leading to unexpected potential losses.

Read Also: What are value mutual funds?

Conclusion

Notional value is a concept that plays a key role in derivatives, futures, options and swap contracts. It helps investors and traders understand the size and potential exposure of their positions without necessarily reflecting the amount of money exchanged.

FAQs:

What is notional value in derivatives?

Notional value is a term commonly used in derivatives trading. It refers to the total value of the asset linked to a contract. This could mean the full value of the position, the amount of value being controlled, or a fixed amount agreed upon in the contract.

Is notional value real money?

Notional value is not the actual money paid or received. It’s a reference figure that helps calculate potential profits, losses or interest payments.

How is notional value calculated?

Two variables are required to calculate notional value. These include contract size and underlying price. The formula for calculation is:

Notional Value = Contract Size x Underlying Price

Why does notional value matter?

• Helps assess total exposure in leveraged trades.
• Assists in calculating margin requirements.
• It is used by regulators and institutions for risk monitoring.
• Plays a role in managing portfolio allocation in derivatives.

Does notional value impact margin?

Yes, notional value directly impacts margin. The exchange or brokerage firm may set margin requirements as a percentage of the notional value.