Notional Value vs. Market Value
Stock trading is an intricate subject that needs extensive knowledge about prices, techniques, companies, portfolio goals, etc. To acquire profits, one needs a diversified portfolio. To achieve this investment goal, it is important to be familiar with important terms like notional value and the market value of the stocks. Both these values determine the value of financial security but in a different context.
In today’s article, we will discuss the difference between notional value and market value, their definitions, and their uses with some examples.
What is notional value?
Notional value is often used to define the value of underlying assets for derivatives such as swaps, futures, or equity options. It can be calculated by using the spot price per contract and multiplying the same with the number of contracts.
Derivatives are complex financial instruments and often use leverage–investing small amounts via borrowing to win huge. For example, an individual can leverage 1,00,000 cash available in his Demat account to trade 10X on the available cash. It means that he can do trading of Rs. 10,00,000 from a small amount.
Because of this, it often becomes difficult to find the actual value of derivatives, and thus, notional value is quite crucial. It helps find the total amount or the value of a derivative position.
It is important to know that notional value typically has higher numbers compared to the market value. It is a useful tool for risk assessment analysis of a portfolio. Unlike the market value, notional value usually remains fixed for security and is not likely to fluctuate.
What is market value?
Market value is the value of a stock that is derived by the demand and supply and the way and the quantity traded by buyers and sellers based on market forces. In essence, it’s the value at which a security can be bought and sold in the market.
We can also call market value market capitalization when referring to the value of a company’s stock position in the market. Capitalization can be calculated by multiplying the number of shares by the current stock price prevailing in the market. The market price is volatile, and its value increases or decreases as the investors buy or sell shares.
For instance, if the demand for a stock exceeds its supply, the market price will rise. While, if the investors start selling a stock rapidly, the price will fall. The primary goal of market value is to decide an asset’s worth in both liquid and illiquid markets.
Some factors that affect the market value of a stock are:
- Market perception
- Economic conditions
- Government policies/actions
- Natural causes
- International transactions
When the market price rises, we typically refer to it as a bullish stance, while if it is opposite, we call it a bearish stance.
Understanding the notional and market values with examples
Let’s look at some examples to understand both these values in a better way.
Notional Value
Equity contract A consists of 200 underlying shares, which means upon completion of the contract, the trader would get access to these shares. The option currently costs Rs. 5, and the spot price is Rs. 25.
The cost of buying the contract for the trader is 5 x 200 = 1000.
The notional value for derivatives contracts will be:
Notional value = Total underlying shares x Spot price
= 200 x 25
= 5000
So, the trader would receive the right to buy 200 shares for Rs. 1000 instead of Rs. 5000.
Notional value here helps in finding the actual worth of the contact.
Market Value
Suppose the company ABC has 6,00,000 shares in circulation in the market, and the price of each share is Rs. 1000. The market value of these shares would be:
Market value = Total outstanding shares x Current price of a share
= 6,00,000 x 1000
= 60,00,00,000
Thus, the market value or market cap of the company ABC is Rs. 60,00,00,000.
How are notional and market values used in practice?
Some of the most common uses of notional value are in interest rate swaps, equity options, foreign currency exchange, total return swaps, foreign currency derivatives, and ETFs (Exchange-traded funds). It helps traders and investors make important decisions related to their deals to gain the upper hand.
Market value is an important term because it helps in assessing the price that investors are willing to pay for a stock. It shows the worth of stock in the market and the buyer’s and seller’s perceptions of it. Companies, as well as investors, can understand whether the stocks are currently undervalued or overvalued and, if they are, how much the difference is. This is a very important piece of information for making investment decisions.
Notional value is quoted for derivatives mainly, while market value is the current price at which a share or security can be bought or sold in the open market.
Basic differences between notional and market value
The differences between these two important values that investors should know are as below.
Conclusion
Notional and market value — both indicate different values that investors should know before starting their investment journey. The difference between these values is simple. The notional value defines the value of derivatives in a transaction. On the other hand, market value defines the price of a company’s stock as being traded in the market. They both have their importance and are used frequently by businesses and investors in the finance world.
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