Definition and Example
The notional value of a derivatives contract is the price of the underlying asset multiplied by the number of units of the underlying asset involved in the contract. Investors can use derivatives like options or futures contracts as a means to add leverage to their portfolio, to hedge against specific market conditions, or to benefit from declining prices.
How Does Notional Value of Derivatives Work?
The notional value of a derivative expresses the total value of the assets involved in the contract. This makes notional value a useful metric because it allows investors to understand the value of the assets in the contracts they are buying or selling.
Notional value typically comes into play when investors are attempting to hedge their portfolios. For example, let’s take a small S&P 500 futures contract. Each unit of this contract is worth $50 multiplied by the value of the S&P 500 index. Let’s assume that the S&P 500 is at 4000; the notional value of one small S&P 500 futures contract would be 50 × 4000 = $200,000.
Now imagine an investor with $10 million invested in a diversified portfolio of U.S. stocks. The investor wants to hedge the portfolio against a significant drop in stock prices. The investor may use small S&P 500 futures contracts to hedge their investments.
If the notional value of one small S&P 500 futures contract is $200,000, then the investor needs to sell:
$10 million / $200,000 = 50 contracts
The price for the 50 contracts would be far less than $10 million, but the notional value is what allows the investor to understand how much underlying assets would be included in those contracts.
Notional Value vs. Intrinsic Value
Notional value and intrinsic value are two measures of value that derivatives traders frequently use, but each term describes very different things.
Notional Value:
- Describes the value of the underlying assets in a derivatives contract.
- Affected by changes in the price of the underlying asset.
- Often used to measure trading volume in derivatives.
- Used to make hedging decisions.
Intrinsic Value:
- Describes the profit an investor would receive if exercising the derivatives contract at that moment.
- Affected by changes in the price of the underlying asset.
- Not useful for measuring trading volume.
- Used to make hedging decisions.
For example, an options contract typically includes 100 shares of stock. If XYZ is trading at $10, then one contract of XYZ has a notional value of $1,000 because it controls $1,000 worth of XYZ stock.
If an investor owns a put option on XYZ with a strike price of $11, then the intrinsic value of that contract is $100 because they can exercise the contract to buy the shares at a $100 discount from their market price.
While notional value allows investors to know how many contracts they need to purchase to hedge a position of a certain size, intrinsic value helps investors calculate the profit they could earn when exercising the contract. It is one of the main determinants of the market value of the option.
What Does This Mean for Individual Investors?
Most individual investors probably do not invest large enough amounts to feel the need to significantly hedge their portfolios. However, if you are trading options or other derivatives, understanding notional value can be helpful as it can assist you in measuring trading volume.
The higher the notional value traded in a particular derivatives market, the more trading volume that is typically seen for those contracts. If you want to trade in highly liquid derivatives, looking at the notional value can help you find options, futures, and other derivatives to trade.
Source: https://www.thebalancemoney.com/what-is-the-notional-value-of-derivatives-5224626
“`
Leave a Reply