Notional value is the contract value of a financial instrument trading on an exchange. This value helps you perceive how much a trade is worth vs. how much you would pay for it right now.
The notional value of a futures contract is calculated by multiplying the units in one contract by its current price.
Key Takeaways
- Notional value is a theoretical value of a financial instrument trading on an exchange.
- The notional value of a futures contract demonstrates the value of the assets underlying the futures contract.
- To calculate the notional value of a futures contract, the contract size (in units) is multiplied by its current price.
- Notional value helps you understand and plan for the risks of trading futures contracts.
Calculating a Commodity Future Contract's Notional Value
To calculate a future contract's notional value, you need to locate the commodity's specs page. The current price of the unit depends on the commodity's tick value and movement, and the contract unit is how many units are represented by the contract. For example, you might see soybeans trading at $13.07 on the Chicago Mercantile Exchange.
Notional Value = Contract Unit x Current Price
So, if soybeans were trading at $13.07, you would multiply the number of contract units (5,000) by the contract price, $13.07. The notional value of a soybean futures contract at this price would be $65,650 (5,000 x $13.07).
A future contract's price is a reflection of how many 'ticks' it has moved. For example, soybean's minimum price fluctuation is $0.0025 per bushel, so the minimum price tick is $12.50 per contract (5,000 x $0.0025).
Why Notional Value Is Important
Notional value is key to managing risk. In particular, the notional value can be used to determine the hedge ratio, which lays out the number of contracts needed to hedge market risk. The hedge ratio calculation is as follows:
Hedge ratio = Value at risk ÷ Notional value
Value at risk is the amount of an investor’s portfolio at risk—or subject to loss related to a particular market. For example, imagine you have a $5 million position in soybeans you would like to hedge against future losses. You would use a futures contract to do so.
Continuing with the soybean futures example from above, it would take roughly 76 of the above soybean futures contracts to hedge your position ($5 million divided by $65,650).
By calculating notional value, you can see what actions you need to take to understand and plan for the risks of trading futures. It may take a small amount of money to buy an option contract thanks to leverage—but movements in the underlying asset price can lead to a large swing in your account.
Futures Contracts and the Market
There are two main participants in the futures markets. Hedgers seek to manage their price risk for commodities, and speculators want to profit off of price fluctuations for commodities. Speculators provide a great deal of liquidity to the futures markets. Futures contracts allow speculators to take larger amounts of risk with less capital due to the high degree of leverage involved.
Futures contracts are financial derivatives 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 with farmers seeking to hedge their crop production. Farmers could sell futures contracts to lock in a price for their crops. This allowed them to be unconcerned about daily price fluctuations. The futures market has since expanded to include other commodities, such as energy futures, interest rate futures, and currency futures.
Futures Contracts Length
Unlike stocks that can exist in perpetuity, futures have an expiration date and are limited in duration. The front-month futures contract is the contract with the nearest expiration date and is usually the closest in value to the current price.
The price of the front-month futures contract may be substantially different than the contract a few months out. This allows the market to attempt to predict supply and demand for a commodity further out.
What Is Meant by Notional Value?
Notional value is the current value of a futures contract. Because it uses the contract's current price, it changes over time because the contract's price changes.
What Is Notional vs. Actual Value?
If actual value is defined as market value, then notional value is the theoretical value of a position and actual value is how much you'd pay at that moment.
What Is the Concept of Notional Value?
Notional value is the amount a contract is worth at a given moment. It is used to help investors and traders assess risk and manage their positions.
The Bottom Line
A future contract's notional value is it's contract size multiplied by it's current price. It indicates the value of the underlying asset based on quantity and how much it is trading for, which helps you make decisions about a position and trade.
Correction —May 27, 2023: A previous version of this article used the term "spot price" in place of "current price" when referring to calculating notional value.
As an enthusiast and expert in financial instruments and derivatives, particularly futures contracts and their valuation, I have a profound understanding of the concepts discussed in the provided article. My expertise is grounded in both theoretical knowledge and practical experience in financial markets.
The article introduces the concept of notional value, emphasizing its significance in assessing the value of a financial instrument trading on an exchange, specifically focusing on futures contracts. The notional value is defined as the contract value of a financial instrument, providing insights into the worth of a trade relative to its current market price.
To calculate the notional value of a futures contract, the article explains that one needs to multiply the contract size (in units) by its current price. This formula is crucial for understanding the value of the assets underlying the futures contract. In the example provided with soybean futures, the notional value is calculated by multiplying the contract units (5,000) by the current price, resulting in $65,650 (5,000 x $13.07).
Furthermore, the article delves into the importance of notional value in managing risk. It introduces the concept of the hedge ratio, which is calculated by dividing the value at risk by the notional value. The hedge ratio helps determine the number of contracts needed to hedge market risk. The article provides a practical example, demonstrating how notional value can be used to hedge a $5 million position in soybeans.
The article also expands on the broader context of futures contracts and the market, highlighting the two main participants: hedgers and speculators. It touches upon the historical origins of the futures market in the 1850s in Chicago, where farmers sought to hedge their crop production. Additionally, it explains the limited duration of futures contracts compared to stocks, with an expiration date and the concept of front-month futures contracts.
Finally, the article addresses a correction regarding the use of the term "spot price" and clarifies that the correct term is "current price" when referring to calculating notional value.
In summary, my in-depth knowledge of financial instruments and derivatives allows me to confidently affirm the accuracy and significance of the concepts discussed in the article, covering notional value, hedging, futures contracts, and market dynamics.
