Updated Mar 20, 2022

What is an underlying asset?

What is an underlying asset?

The security on which a derivative contract is based is known as the underlying asset. The cost of the derivative could be directly (e.g. call option) or inversely (e.g. put option) associated with the value of the underlying asset. A stock, commodity, index, currency, or even a derivative (e.g. volatility index, VIX) product might be used as an underlying asset. The underlying asset of some exotic derivatives, such as weather derivatives, may be a non-financial entity.

Typically, the underlying asset trades on a spot market (particularly when the underlying is a financial asset), where the asset must be purchased in full upfront (or within 1-2 days). Derivatives based on such assets typically do not require a 100% upfront payment to gain exposure to them, implying that they have a built-in element of leverage. The majority of listed stocks traded on stock exchanges serve as the underlying asset for futures and options contracts based on them. Take, for example, ITC, a stock that trades on the Indian stock exchanges.

Understanding Derivative Contracts

An option or futures contract's price is determined by the price of the underlying asset. The writer of an option contract must either buy or sell the underlying asset to the buyer at the agreed-upon price on the designated date. The buyer is not compelled to buy the underlying asset, but they have the option to do so if they so desire. If the option is close to expiry and the underlying asset has not changed sufficiently in the buyer's favor to make exercising the option worthwhile, the buyer can let the option expire and lose the money they bought for it.

A futures contract is an agreement between a buyer and a seller. The seller of a futures contract commits to deliver the underlying asset at expiration, and the buyer of the contract agrees to purchase the underlying asset at expiration. The price they received and paid when they entered the futures contract is the same amount they paid when they entered it. Because ordinary traders and hedge funds have little need to take physical custody of barrels of oil, for example, most futures traders close out their contracts before expiration. However, they can purchase or sell the contract at a fixed price, and if the market swings in their favor, they can exit the transaction and profit.  Because the price of an oil futures contract, for example, is depending on the price movement of oil, futures are considered derivatives.

Types of Underlying Assets

In the futures trading market, underlying assets come in a variety of types:

Stocks

Stocks are one of the most extensively used underlying assets, which is understandable considering their pervasiveness in the investment industry.

When making market moves, derivatives traders use ordinary and preferred stocks as benchmark assets. Because stocks are so widely traded, they provide greater opportunities for derivatives investors to speculate, hedge, and leverage equities as an underlying asset.

Bonds and Fixed Income Instruments

Bonds are such as Treasury, municipal, and corporate bonds that are employed as derivative instruments as well. Because bond prices change in response to broad economic and market conditions, derivative investors may attempt to leverage bonds as an underlying asset, while both bond interest rates and prices fluctuate.

Index Funds

Funds are also used as underlying assets by derivative traders, particularly exchange-traded funds (ETFs), which are commonly traded during intraday trading sessions. Exchange-traded funds are tradeable on major worldwide exchanges at any time of the trading day, in addition to being extremely liquid and relatively straightforward to trade.

Mutual funds, on the other hand, can only be traded after the trading session has ended for the day. The disparity is significant for derivative traders, who have greater market movement opportunities with ETFs than with mutual funds.

Stocks, bonds, commodities, foreign and emerging markets, and business sector funds are among the investment market sectors covered by ETFs (i.e., such as manufacturing, health care, finance, and more recently, cryptocurrencies). This availability allows derivatives investors even more flexibility, which is a feature that underlying asset investors normally prefer.

Currencies

Derivative investors typically use global currencies as underlying assets, such as the dollar or the yen, among many others. The often fast-moving foreign currency (FX) market, where prices can vary quickly based on geopolitical, economic, and market situations, is one of the main reasons.

Currencies tend to trade quickly and frequently, which can lead to a tumultuous market — and derivative investors want to put their money into underlying assets that exhibit volatility, as quick market moves provide quick profit chances. Because currencies change so quickly, they can also move in the wrong direction, which is why investment experts often advise individual investors to avoid markets with high levels of risk.

Commodities

Gold, silver, platinum, and oil and gas are all common global commodities that are employed as underlying assets by derivatives investors.

Commodities have a reputation for being one of the most volatile and fast-moving financial markets in history. Commodities, like currencies, are frequently sought after by derivative traders. However, extreme volatility can result in huge investment losses in the derivatives market if the investor lacks the experience and intelligence required to trade against underlying assets.

Conclusion

The underlying assets employed in derivative trades can be risky, and trading against them necessitates a thorough understanding of trading, leverage, hedging, and speculating. High-end investing firms, hedge funds, and other institutional investors are known for having these characteristics. They're not usually connected with ordinary folks trying to save for retirement and develop wealth in their households.