Underlying Asset

An underlying asset is a financial asset that determines the price of a derivative, such as a stock, bond, or commodity.
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Underlying Asset
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3 mins read
19-November-2024

The asset or asset class on which a derivative's price is based is known as its underlying asset. Think of it as the real financial asset, which determines the value of a derivative contract—a popular trading instrument. Understanding the concept and meaning of an underlying asset is crucial for any trader because it helps in assessing the risk and value of the derivative.

What is underlying asset?

An underlying asset is the real financial asset that gives value to a derivative, like a stock, bond, or commodity. The derivative’s price depends on how the underlying asset performs. For example, in a stock option, the stock is the underlying asset, and its price changes impact the option’s value. Different types of underlying assets, such as stocks, bonds, and commodities, come with their own risks. Stocks can be volatile, bonds are sensitive to interest rates, and commodities may fluctuate with supply and demand. Knowing these risks helps in making better investment choices.

What are derivatives?

Derivatives are financial contracts whose value depends on—or ‘derived’ from—an underlying asset. They are used for various purposes, including hedging risks and speculating on the future price movements of an asset. Common forms of derivatives include futures, options, forwards, and swaps.

The underlying asset meaning becomes clearer when you see how derivatives work. For example, a gold futures contract is a type of derivative where the underlying asset is gold. The price of this contract fluctuates based on the price movements of gold in the market.

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Types of underlying assets

There are several types of underlying assets. Each type has its own unique characteristics and risks, which influence the pricing and behaviour of the derivatives linked to them. Here are some common categories of underlying assets:

  • Commodities: Commodities are physical goods that can be traded. Common underlying assets examples in this category include gold, silver, crude oil, natural gas, wheat, and coffee.
  • Stocks: Stocks represent ownership in a company and are frequently used as underlying assets in options and futures contracts.
  • Bonds: Bonds are debt securities issued by governments or corporations to raise capital for various initiatives and projects. They can be used as underlying assets for different derivatives, such as bond futures and options.
  • Currencies: Currencies are another common type of underlying asset, particularly in the foreign exchange (forex) market. Currency pairs like USD/INR or EUR/INR are used as underlying assets in forex derivatives, including currency futures, options, and swaps.
  • Interest rates: Interest rates can also be underlying assets for derivatives such as interest rate swaps and futures. These derivatives allow the involved parties to hedge or speculate on changes in interest rates.
  • Market indices: Stock market indices like the Nifty 50 or S&P BSE Sensex can be the underlying asset for index futures and options. These derivatives are based on the performance of a group of stocks that make up the index.
  • Real estate: Real estate can also serve as an underlying asset for certain types of derivatives, such as real estate investment trusts (REITs) or real estate futures. These derivatives allow you to gain exposure to the real estate market without directly owning property.

Also read: What is asset allocation

What is the relationship between underlying assets and derivatives?

The relationship between an underlying asset and a derivative is important to understand for anyone trading or investing in derivatives. The value of the derivative is directly influenced by the price movements of the underlying asset and the performance of the derivative is inherently linked to the performance of the underlying asset. For example, if you hold a call option for a stock (which is the underlying asset), the value of this option will increase if the stock price goes up.

This relationship allows traders and investors to use derivatives for hedging by offsetting potential losses in the underlying asset with gains in the derivative or for speculative purposes by attempting to profit from anticipated price movements.

What is the importance of underlying assets?

The importance of underlying assets in the world of finance is vital. They serve as the foundation upon which derivatives are built. Here are some key reasons why underlying assets are important:

  • Valuation: The value of a derivative is determined by the value of its underlying asset. Therefore, the accurate valuation of the underlying asset is crucial for the correct pricing of the derivative.
  • Risk management: Derivatives are often used to hedge against risks associated with the underlying asset. For example, a farmer might use futures contracts to lock in a price for their crop, thus hedging against the risk of a drop in its price.
  • Market efficiency: The trading of derivatives based on underlying assets can improve market efficiency by providing additional liquidity and enabling accurate price discovery.
  • Investment strategies: Investors use derivatives to gain exposure to underlying assets without actually holding the asset. This can be more cost-effective and provides flexibility in trading strategies.

Understanding the underlying asset meaning and recognising underlying asset examples are essential for making informed investment decisions and managing financial risks effectively.

Conclusion

In summary, an underlying asset is the foundation of the derivatives market. It is the tangible or intangible asset from which a derivative acquires its value. Understanding the meaning of an underlying asset is critical for anyone involved in financial markets. Whether it is commodities, stocks, bonds, or currencies, each type of underlying asset comes with its own set of characteristics and risks. The relationship between underlying assets and derivatives allows for a wide range of financial strategies, including risk management and speculative trading. By appreciating the importance of underlying assets, you can make more informed decisions and effectively navigate the complexities of the financial markets.

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Frequently asked questions

What is the difference between underlying assets and derivatives?
An underlying asset is the actual asset on which a derivative is based, such as a stock, bond, commodity, or currency. A derivative is a financial contract whose value is derived from the price movements of the underlying asset. Examples of derivatives include futures, options, forwards, and swaps.
What is an example of an underlying stock?
An example of an underlying stock is shares of Company X in a stock option contract. For example, if you have an option to purchase 100 shares of Company X at Rs. 8,000 per share, the underlying asset is the stock of Company X. The value of this stock determines the value of the option until it expires. Changes in the stock's value before the contract's expiration affect the option's worth, which in turn helps you decide whether to exercise the option or let it expire.
Why are underlying assets important in finance?
Underlying assets are important because they determine the value of derivatives. Understanding the underlying asset meaning helps in assessing the risk and potential returns of the derivative. They are also essential for hedging strategies, as they allow you to offset potential losses in the underlying asset with gains in the derivative.
What is another name for an underlying asset?

An underlying asset is also known as a base asset. It's the primary asset on which a derivative, such as a futures contract or option, is based.

What is the underlying asset in Nifty 50?

The underlying asset for the Nifty 50 index is a basket of 50 stocks representing the top companies listed on the National Stock Exchange of India (NSE). These stocks are selected based on market capitalization and liquidity.

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