Derivatives are essentially contracts that derive their worth from an underlying financial asset. They can be used for various purposes, such as hedging and giving one exposure to more of these assets. To that end, there are several types of derivatives.
The first type is futures. These are contracts between a buyer and seller to exchange a fixed amount of an asset at a specified price on a future date. The second one is options that grant a trader the right to buy an underlying asset at a specified price on or before its maturity date. However, they are under no obligation to complete the transaction upon maturity. The third type, swaps, allows two parties to exchange cash flows on an underlying asset. These include interest rate swaps, commodity swaps, and currency swaps.
Why trade derivatives?
As aforementioned, derivatives are preferred for the numerous perks, they offer investors.
These include:
- Hedging against risk
Suppose an investor holds a certain asset in large amounts, like a commodity such as copper. In that case, they could utilize derivatives contracts to hedge against any losses from a drop in copper prices. The derivative, in this case, would have to have a negative price correlation with copper.
- They determine the market prices of financial assets
Derivatives are often used to set market prices in the spot market. For instance, the spot prices of a commodity’s futures can be used to approximate the commodity’s current market price.
- They grant one exposure to unavailable markets
For instance, if a company involved in imports and exports utilized interest rate swaps, they could benefit from better rates than if they directly borrowed the foreign currency they needed.
The notional value of derivatives explained
This is a measure that attempts to quantify how much money a derivatives contract is worth. It is obtained by multiplying the price per unit of the underlying asset multiplied by the number of units that make up the contract.
For example, in the oil market, crude oil is quantified in barrels. Usually, a futures contract for oil contains 1,000 barrels. If the current market price of oil is $90 per barrel, then the contract would be worth $(1,000 * 90) = $9,000. This is its notional value.
In the case of gold, one futures contract could have a typical weight of 100 troy ounces, the weight of one gold ingot. Therefore, assuming gold is retailing at $2,000 per ounce, the notional value of this contract would be $(2,000 * 100) = $200,000.
For stock indices, a multiplier is often utilized in the notional value calculation. For instance, let’s assume the E-mini S&P 500 futures contract is priced at $4,000. The multiplier used is $50. In this case, the notional value becomes $(4,000 * 50) = $200,000.
However, you do not have to put up the contract’s notional value to hold the position. Thanks to leverage, you can put up a fraction of the cost while your broker lends you the rest. However, beware of overleveraging your positions, as this can lead to losses exceeding your initial deposit.
Notional value in practice
For our intents and purposes, let’s assume we’re invested in a wide basket of stocks of the largest publicly traded US companies. Our position size is to the tune of $5 million. In the current economic climate, a recession is more than likely, so we can expect a significant downswing in stock prices. To hedge against this risk, we can utilize an S&P 500 futures contract.
Now, recall from our previous example that we established the notional value of an E-mini S&P 500 futures contract to be $200,000. To fully hedge our portfolio, we would need to sell:
$5 million/$200,000 = 25 contracts.
You may notice that the 25 contracts will cost a lot less than the $5 million, even without leverage. However, they will command a position size equivalent to that amount. Please note that if the contract in question is a foreign currency derivative, you would have to consider two notional values, one for each currency involved in the exchange.
What is the difference between the notional and intrinsic value of a derivative?
First off, both of these values are commonly used to quantify derivatives, but they represent different aspects of the contract. The notional value, as we’ve established, attempts to quantify the total monetary value of the underlying asset involved in the contract. The intrinsic value, on the other hand, gives a measure of the profit an investor stands to make if they execute their derivatives contract.
For instance, in stocks, a single options contract comprises 100 shares. In the case of Tesla stock, which is priced at $1,000 per unit at the time of writing, the options contract would be worth:
$(1,000 * 100) = $100,000.
This is its notional value. If we held a put option on Tesla with a strike price of $1050, this would mean that we could sell the stock at a $50 profit a pop, which for the whole contract would translate to a cumulative profit of:
$50 * 100 = $5,000.
Therefore, $5,000 is the intrinsic value of the Tesla options contract.
The long and short of it
Derivatives are contracts that allow investors exposure to an underlying financial asset. These contracts can be used as a hedging strategy against losses from price fluctuations. Speculators also utilize them to profit from the underlying asset’s price fluctuation without needing to physically own the asset. Notional value is a measure that quantifies the monetary value of the assets contained within such a contract. This value can be used to calculate how many units of the contract one would need to execute to hedge their portfolios effectively.
