Introduction:
The concepts of notional value and market value can sound confusing. These terms are closely related and sometimes also used interchangeably by novice and seasoned investors. However, it is essential to understand that the notional and market values are distinct concepts. They play entirely different roles in stock and derivate market investing. Understanding their differences and relevance can help you use them effectively. Keep reading to know more.
What is the notional value?
The notional value is a metric used to describe the total worth of an asset. It includes both the invested amount and the market value of the asset. It shows the difference between the market price paid for an asset and the actual investment amount associated with the entire transaction. The notional value can be calculated by multiplying the units within a contract by the prevailing spot price.
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The notional value can be used when investing in futures, stocks, Exchange-Traded Funds (ETFs), foreign currency exchange, total return swaps, interest rate swaps, and foreign currency derivatives. It is a vital metric used in assessing and managing risk when evaluating diverse financial instruments.
What is the market value?
Market value refers to the agreed-upon price of a security within the marketplace. It is determined between buyers and sellers and is calculated based on the security's demand and supply. It is a comprehensive figure that signifies all market participants' prevailing sentiments and preferences. The market value of a security can be a strong indicator of investor sentiment regarding a company’s business prospects.
Here's an example to help you understand how these two values work:
Suppose you decide to invest in an XYZ Index futures contract. This particular futures contract consists of 200 units, each priced at Rs. 4000 in the market. Therefore, the market value of a single unit is Rs. 4000. Now, if we calculate the notional value of the XYZ Index futures contract, it would be Rs. 4000 multiplied by 200 units, resulting in a notional value of Rs. 8,00,000.
So, in this scenario:
- Market value per unit = Rs. 4000
- Number of units per contract = 200
- Notional value = Rs. 4000 x 200 = Rs. 8,00,000
Differences between the notional and market value of a security
Here are some differences between notional and market value to help you understand their distinctions in detail:
- The market value signifies the underlying value of a derivative contract relative to its market value. It is calculated based on the demand and supply and is a reference point for the contract's total value. In contrast, the notional value represents the current price at which a security or financial contract is available in the marketplace. It reflects the price consensus between buyers and sellers.
- The market value focuses on the price of a single unit of security. It indicates the cost of acquiring this unit in the market. Conversely, the notional value encompasses the entire value of a financial security. It provides a holistic view of the total value of the security based on contract terms.
- The market value represents the actual amount paid for a particular security in the marketplace. It reflects the prevailing dynamics of supply and demand in the market. In contrast, the notional value indicates the total value of the financial security's position. It offers better insight into the aggregate value of an asset.
- The market value signifies the current marketplace perception of the security's worth. However, it is subject to fluctuations influenced by market conditions. The notional value only highlights a financial security's comprehensive position. It serves as a benchmark for understanding the broader financial commitment associated with the derivative contract.
To sum it up
While the market value denotes the immediate cost of acquiring a security, the notional value provides a broader perspective on the total value of a financial security's position. Both values can help you understand whether or not the asset is a good investment based on your financial objectives, goals, and risk appetite.
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