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Notional value is a stock-trading term used to refer to the basis on which derivatives are structured
Derivatives are financial instruments specially constructed to achieve a goal or return in markets. Options, futures, swaps, etc. are derivatives of an underlying security – that could be stock prices, indices, bonds, interest rates, etc.
Notional value is a term you will hear a lot being used amongst derivative traders. In this short article, we’re going to understand what that is, how you make sense of it, and how to use it in your trading.
What is notional value?
In essence, notional value (also referred to as principal amount, face value, or contract amount) is a hypothetical or reference value associated with a financial instrument.
It doesn’t represent the actual cash exchanged upfront or the final payout but serves as a baseline for calculations within the agreement. Here’s an analogy: Imagine a recipe calling for “2 cups of flour.”
The 2 cups represent the notional value, outlining the scale of the recipe, but you wouldn’t necessarily use exactly 2 cups of flour if you were baking in a bigger pan or baking multiple batches at the same time.
Where is notional value most used?
Notional value finds application in various financial instruments, with derivatives being the most prominent example. Here’s a breakdown of some key areas:
Derivatives
These contracts derive their value from underlying assets like stocks, bonds, or currencies. The notional value in a derivative contract acts as the reference point for determining the potential gains or losses.
For instance, an interest rate swap with a notional value of $1 million essentially references a $1 million loan, even though no actual $1 million is initially exchanged.
- Interest rate swaps – These are financial contracts signed and agreed upon based on prevailing interest rates in the market. They’re used to manage interest rate risk for corporations, and are mostly used when companies need to change their fixed rate obligations to floating rate ones, or vice versa.
- Forwards or futures contracts – These agreements commit parties to buy or sell an asset at a predetermined price on a future date. The notional value serves as the basis for calculating potential gains or losses based on price fluctuations.
Imagine Company A and Company B enter an interest rate swap with a notional value of ₹100 crore. Company A agrees to pay Company B a fixed interest rate on this notional amount, while receiving a variable rate in return. While no actual ₹100 crore is exchanged initially, the calculations of fixed and variable interest payments will be based on this reference value.
Bank lending and credit derivatives
If you’re in the market for a loan and approach a bank, they may issue to you loan commitments with a specific notional value, representing the maximum amount they’re willing to lend. While the final amount may differ, the notional provides a framework for you to base your calculations and budgeting on.
Credit derivatives also use notional amounts. These are insurance-like instruments that pay out money when a borrower defaults on their loans. The notional value acts as the reference amount for potential payouts in case of default.
Why is a notional value important if no cash is exchanged?
Understanding the concept of notional value is important for investors like you. This is because:
- It allows you to gauge your exposure – While not representing actual cash flow, the notional value helps assess the potential gains or losses associated with a financial instrument. In a derivative contract, a higher notional value translates to a larger potential impact, highlighting the higher risk associated.
- It allows institutions to manage risk – Financial institutions use notional value to calculate risk metrics like Value at Risk (VaR), which estimates potential losses within a specific timeframe. This allows them to lend to credit-worthy borrowers and reduce their overall risk.
- Benchmarking – In more complicated instruments, the notional can be used as a reference point for calculating intermediary fees and returns too.
Frequently Asked Questions
Not really. Notional value isn’t the same as stock price. It’s more like a reference point used in some financial agreements involving stocks, not the actual price you pay to buy a share.
Options contracts often have a notional value that reflects the underlying asset (like a stock) they’re based on. It helps calculate potential gains or losses, but you wouldn’t pay the full notional value upfront when buying the option.
Sometimes, loan commitments might have a notional value stating the maximum amount the lender is willing to offer, not the exact amount you borrow initially.
It helps understand the scale of a financial agreement. A higher notional value in a derivative contract could mean a bigger potential gain or loss, even though you might not exchange the full amount upfront.
While not the actual cash involved, notional value helps assess potential risk. Look at it alongside other factors like the underlying asset or interest rate movements to make informed decisions.