The face amount of underlying exposure a derivative contract controls, as distinct from the cash committed to open the position. The gap between the two is the source of leverage: a small option premium or futures margin deposit carries the full move on the notional amount, which magnifies gains and losses alike.
Practice questions using Notional Value
Original questions written against the published FINRA and NASAA exam content outlines — not actual exam questions. Every choice is explained.
A client deposits initial margin to open a long futures position. If the market moves sharply against her, the maximum amount she can lose is
A.the initial margin, which functions much like the premium on a purchased option.Wrong. Margin secures an obligation rather than purchasing a right, so it caps nothing.
B.the initial margin plus whatever maintenance margin the exchange requires.Wrong. Maintenance margin is the level that triggers a call, not a ceiling on the total loss.
C.not limited to the deposit, since she remains liable for the full loss on the contract.Correct. The obligation runs on the notional amount, and the deposit merely secures it.
D.the notional value of the contract, which the exchange collects at the outset.Wrong. Nothing close to notional value is collected up front, which is precisely what creates the leverage.
Why: Initial margin on a futures contract is a good-faith deposit securing performance of an obligation, not the price of the position, and it does not cap the loss. The holder is liable for the full adverse move on the notional amount of the contract, which is settled daily through variation margin and can exceed the original deposit many times over in a fast market. That open-ended exposure is the single most important difference between a futures position and a long option, where the premium paid is the entire risk. It is also why futures accounts carry their own disclosure and approval requirements.
An adviser hedges an equity portfolio by buying index puts with a total notional value equal to the portfolio value. The portfolio has a beta well above one. In a broad market decline, the hedge will
A.cover the loss exactly, since the notional amounts on the two sides match.Wrong. Matching dollars matches size, and it is sensitivity rather than size that determines the payout needed.
B.overshoot, because a portfolio with a high beta falls by less than the index.Wrong. That inverts the meaning of beta above one, which describes larger moves rather than smaller ones.
C.fall short, because the portfolio declines by more than the index does.Correct. A beta above one means the loss outruns the index-based payout unless the hedge is scaled up.
D.cover the loss, provided the puts are held all the way to expiration.Wrong. Holding to expiration changes when the hedge settles, not how much of the loss it can cover.
Why: Matching notional value matches the size of the two positions but not their sensitivity to the market. A portfolio with beta above one falls by more than the index in percentage terms, so puts sized to the index will pay out less than the portfolio loses and the hedge is only partial. Sizing the hedge properly means scaling the notional amount by the portfolio beta, so a higher beta requires more contracts rather than the same number. If the portfolio tracked the index exactly, matching notional value would be the right approach.
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