NOTIONAL AMOUNT: Meaning, Formula and Uses

NOTIONAL AMOUNT: Meaning, Formula and Uses
NOTIONAL AMOUNT: Meaning, Formula and Uses

Notional amount or notional principal amount is the nominal value on the basis of which payment calculations for a financial instrument (for example, a swap) are determined. 

In other words, the notional amount indicates how much money is controlled by a position in a particular financial instrument.

Notional value is quoted for various derivatives such as swaps, stock options and futures.  It is usually used to distinguish the total cost of the position from the total cost required to obtain the position.

What Is Notional Amount?

Notional amount is a stock exchange term often used in the context of the valuation of the underlying assets when trading derivatives.  This can be the total value of a particular position, the amount of value controlled by the position, or an agreed, predetermined amount in the contract. 

Generally, the term notional value is used to describe derivative contracts in the futures, options and foreign exchange markets. The notional value of a derivative 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 such as options or futures as a way to add leverage to their portfolio, hedge against specific market conditions, or profit from falling prices.

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How Does It Work?

In foreign exchange, a notional amount, also known as notional principal or notional value, is the amount of currency that can be sold or bought.

It is important to remember that there are always two denominations in FX, as a currency exchange always involves two currencies. A party to a currency transaction always has two underlying notional amounts, the currency bought and the currency sold.

For example, a company may decide to purchase €1,000, which will cost $1,100.  Therefore, the conditional amount in the US dollar is 1310, and in the euro – 1000. Notional amount is also often used in options and futures markets as the total value of leveraged assets.

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Notional Amount Example

For example, consider the E-mini S&P 500 futures contract. Each unit of this contract is equal to $50 times the value of the S&P 500 index. Suppose the S&P 500 index is 4,000;  the notional value of one E-mini S&P futures contract would be $50 x $4,000 = $200,000.

Now imagine an investor who invested $10 million in a diversified portfolio of US stocks.  They want to protect their portfolio from a significant drop in stock prices.  An investor can use E-mini S&P 500 futures contracts to hedge their investment.

If the notional value of one S&P 500 futures contract is $200,000, then to fully hedge his portfolio, the investor must sell:  $10 million / $200,000 = 50 contracts

The price of 50 contracts will be significantly less than $10 million, but the notional value is what allows the investor to understand how much of the underlying asset these contracts will cover.

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What Is Derivative Notional Amount?

The notional value of a derivative 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 such as options or futures as a way to add leverage to their portfolio, hedge against specific market conditions, or profit from falling prices.

The notional value of a derivative 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 such as options or futures as a way to add leverage to their portfolio, hedge against specific market conditions, or profit from falling prices.

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What Is Notional Amount Swap?

Notional Amount Swaps are swaps in which counterparties agree to exchange future interest payments.  Interest payments are calculated based on a predetermined notional principal value.  Notional value can be expressed in any currency and take any value.

Interest payments payable are calculated periodically by multiplying the applicable interest rates by the notional principal amount.  Strictly speaking, the notional principal value in interest rate swaps is a purely theoretical value that is used only to calculate interest payments.

Currency swaps can be thought of as a type of interest rate swap in which counterparties exchange principal and interest payments denominated in different currencies (for example, the US dollar versus the British pound). 

Similar to interest rate swaps, the calculation of interest rate payments for currency swaps is also based on predefined notional principal values.

Please note that currency swaps involve two notional values ​​expressed in two different currencies.  Unlike interest rate swaps, currency swaps also involve the exchange of a notional principal value.

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Difference Between Notional Value Vs Market Value

The concept of conditional value should not be confused with the concept of market value.  Although both terms describe the cost of financial security, the concepts are used in different contexts.

Notional value is the total value of a position in a financial security.  Strictly speaking, it determines how much money a position in control of securities takes.  In other words, value can be viewed as the theoretical value of a position in securities.

Conversely, market value indicates the market value of securities as determined by buyers and sellers.  It is essentially the price of a financial security at which it can be bought or sold.  Therefore, market value is the actual value of a position in securities.

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How To Calculate Notional Amount

Each derivative contract has unique multiples, weights, volumes or other factors to describe the underlying asset.  One example would be one unit of a 100 troy ounce gold futures contract. 

The notional value is 100 times higher than the market price of gold according to the notional value formula:

When an investor wants to buy a derivative contract, he will pay at this predetermined price.  For example, if someone bought a gold futures contract for 10 units, that would be multiplied by 100 for a total notional value of $1,000. 

However, due to the concept of leverage, the investor will not need to pay the full notional value.  Instead, they will pay market value or initial margin.

In other words, when you buy forward contracts, you must multiply the units by the price to determine the notional value or spot price.

Conclusion

Notional value is an important guideline for investors, especially when assessing risk.  Investors and analysts can use notional value to calculate hedge ratios and offset portfolio risk.  Here’s how you use notional value and risk as a formula to calculate hedge ratios:

The notional value is not only useful for futures contracts as described above, but can also be used for things like stock options, foreign currency derivatives, interest rate swaps, and any other contract involving the price of an underlying asset.

Notional Amount FAQs

What Are Currency Swaps?

Currency swaps can be thought of as a type of interest rate swap in which counterparties exchange principal and interest payments denominated in different currencies (for example, the US dollar versus the British pound).  Similar to interest rate swaps, the calculation of interest rate payments for currency swaps is also based on predefined notional principal values.

What Is The Face Value Of Equity Options?

Stock options (such as calls or puts) give the right, but not the obligation, to buy or sell the underlying stock at a specified price at a specified time in the future.  Typically, each option gives you the option to buy or sell 100 shares.  The face value of equity options is the total value of the option position held by the investor.

What Is Interest Rate Swap?

An interest rate swap is a contract in which parties agree to exchange future interest payments with each other.  Interest is calculated on the basis of the conditional principal amount, which is determined in advance.  Interest amounts are calculated by multiplying the relevant interest rates by the conditional principal amount.  Thus, this value is the basis for calculating interest.

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