The term notional value refers to the value or spot price of the underlying asset in derivatives trading, be it an option, futures or currency. This value helps you understand the difference between the total investment amount and the total amount associated with the entire transaction. The notional value is calculated by multiplying the units in one contract by the spot price.
Although both describe the value of a security, notional value differs from market value. Market value is commonly used to describe the market capitalization of a public company. It can also be used to describe the price of an asset in the open market. To get the market value, multiply the total number of shares outstanding by the current share price. But how to calculate the notional value of a futures contract?
- The term notional value refers to the value or spot price of the underlying asset in a derivative trade.
- Calculating the notional value of a futures contract determines the value of the asset underlying the futures contract.
- To calculate the notional value of a futures contract, the contract size is multiplied by the price per unit of the commodity represented by the spot price.
- Notional value helps investors understand and plan for the risk of loss.
Calculation of the notional value of the futures contract
Calculating the notional value of a futures contract determines the value of the asset underlying the futures contract. The spot price is current price goods. For this, the size of the contract is multiplied by the price per unit of the commodity represented by the spot price.
Notional Value = Contract Size x Spot Price
For example, one soybean contract consists of 5,000 bushels of soybeans. At a spot price of $9, the notional value of the soybean futures contract is $45,000, or 5,000 bushels times the spot price of $9.
Understanding the calculation of notional value
The notional value calculation shows the total value of the underlying asset or commodity that controls the contract. As with soybeans, one soybean contract represents $45,000 of this asset. But this figure does not match the market value of the option that is currently traded in the market.
Market Value of Option = Option Price x Claim on Underlying Assets
If the soybean contract in the above example is trading at $2, then the market value of the option would be $10,000—or the option price of $2 times 5,000 bushels. The difference between the notional value and the market value of an option is due to the fact that options use leverage.
Why Imputed Value is Important
Notional value is key to risk management. In particular, the notional value can be used to determine the hedge ratio, which determines the number of contracts needed to hedge market risk. Calculation of the hedging ratio:
Hedge Ratio = Value at Risk ÷ Notional Value
Value at risk is the amount of an investor’s portfolio that is at risk or may suffer losses related to a particular market. For example, an investor has a $5 million position in soybeans that he would like to hedge against future losses. For this, they will use a futures contract.
Continuing with the soybean futures example above, it would take approximately 111 of the above soybean futures contracts to hedge their position, or $5 million divided by $45,000.
Notional value helps investors understand and plan for the risk of loss. It may take a small amount of money to buy an option contract thanks to leverage, but changes in the value of the underlying asset can cause large fluctuations in the investor’s account.
Notional value is key to risk management because it helps investors understand and plan for the risk of loss.
Futures contracts and the market
There are two main players in futures markets. Hedgers seek to manage commodity price risk, while speculators seek to profit from commodity price fluctuations. Speculators offer a lot liquidity to futures markets. Futures contracts allow speculators to take on greater risk with less capital due to the high degree leverage involved.
Futures contracts derivative financial instruments with values based on an underlying asset. They are traded on centralized exchanges such as the Chicago Mercantile Exchange (CME) Group or the Intercontinental Exchange (ICE). The futures market began in the 1850s in Chicago, when farmers sought to insure their agricultural products. Farmers could sell futures contracts to lock in the price of their crops. This allowed them not to worry about daily fluctuations in the spot price. Since then, the futures market has expanded to include other commodities such as energy futures, interest rate futures, and currency futures.
Unlike stocks, which can exist continuously, futures have expiration date and limited in duration. The front-month futures contract is the contract with the closest expiration date and is usually the closest in value to the spot price.
The price of a futures contract for the first month can be significantly different from the price of the contract several months later. This allows the market to try to predict supply and demand for the goods further.