Underlying Assets: Definition, Types, and Examples

Underlying assets form the foundation of derivative contracts in financial markets. They represent the core value upon which complex financial instruments like options and futures are built. Understanding what underlying assets are in derivatives is essential for anyone looking to comprehend how derivatives work and their role in modern finance.

What is a derivative in finance?

A derivative is a financial instrument whose value depends entirely on another asset's price. This relationship creates a direct connection between the derivative and its underlying asset, meaning any price movement in the underlying asset will cause corresponding changes in the derivative's value. The most prevalent types of derivatives in financial markets include options, futures, forwards, and swaps.

Derivatives serve multiple purposes in financial markets. Traders use them for speculation and hedging against potential losses, while markets rely on them for price discovery. However, these instruments come with inherent risks including complexity, leverage exposure, counterparty risk, and the potential to contribute to systemic market instability.

What are underlying assets in derivatives?

An underlying asset in derivatives is the fundamental financial instrument from which a derivative contract derives its entire value. This creates an inseparable link between the two: when the underlying asset's price fluctuates, the derivative's value moves in tandem. This relationship is the core principle that makes derivative trading possible and defines what an underlying asset is in the derivatives context.

The two most prevalent derivative types are options and futures, each with distinct characteristics:

Options provide contract buyers with rights rather than obligations. By paying a premium, buyers acquire the right to purchase or sell an asset at a predetermined price within a specific timeframe. If market conditions become unfavorable, buyers can simply allow the contract to expire unused. Options are particularly valuable for hedging strategies. For instance, a Bitcoin holder concerned about potential market downturns might purchase a put option at a price below current market value, effectively creating insurance against significant losses.

Futures contracts differ fundamentally from options by creating binding obligations for both parties. Buyers and sellers must complete the transaction at the agreed-upon price and date specified in the contract. These contracts typically don't require premium payments and are frequently used in commodity markets. A practical example would be a soybean farmer using futures contracts to guarantee a minimum selling price, thereby protecting against potential price crashes during harvest season.

Types of underlying assets in derivatives

The derivatives market encompasses an extensive range of underlying assets. Essentially, any tradable asset can serve as the basis for a derivative contract. The cryptocurrency revolution has significantly expanded both the market size and the variety of underlying assets available for derivatives trading.

Shares represent one of the most established categories of underlying assets in derivatives. Corporate equity commonly underlies options, futures, and equity swap contracts, providing investors with numerous ways to gain exposure to stock price movements without directly owning the shares.

Bonds issued by corporations and governments serve as popular underlying assets for various derivatives including bond options, futures, and interest rate swaps. These instruments allow investors to speculate on or hedge against changes in interest rates and credit risk.

Currencies form the basis for currency derivatives that enable speculation and hedging against exchange rate fluctuations. In the decentralized finance ecosystem, stablecoins exemplify currency-backed derivatives, with coins like USDC maintaining their value by holding equivalent reserves of the pegged currency. Currency derivatives include options, futures, swaps, and forward contracts.

Cryptocurrencies have emerged as a dynamic new category of underlying assets in derivatives. Digital currencies like Bitcoin can underpin various derivative contracts, with options and futures being the most common instruments in crypto markets. These can be traded on various centralized trading platforms and decentralized exchanges.

Indices track the collective performance of security baskets, moving up or down based on the aggregate value of their constituent securities. These serve as underlying assets for futures, options, and swap contracts, allowing investors to gain exposure to entire market sectors or economies.

Real-world items can also function as underlying assets through tokenization. Non-fungible tokens (NFTs) can represent valuable physical assets like artwork or real estate, making these traditionally illiquid assets tradeable and enabling efficient price discovery in digital markets.

Exchange-traded funds (ETFs) are publicly traded investment funds that can serve as underlying assets for ETF options, index futures, and index options, providing diversified exposure through a single instrument.

An interesting historical note: weather derivatives, introduced in the late 1990s, use weather-related indices such as temperature and rainfall as underlying assets. Industries like agriculture, energy, and tourism use these instruments to hedge against revenue losses caused by adverse weather conditions, transforming unpredictable weather patterns into manageable financial risks.

Example of an underlying asset in derivatives

Bitcoin provides an excellent example of how cryptocurrencies function as underlying assets in derivative contracts. Consider a Bitcoin holder who maintains an overall bullish outlook but recognizes the possibility of a short-term market correction within the coming months. To protect against this risk, the holder might purchase a put option contract.

For a premium payment, this contract would grant the right to sell a specific amount of BTC at a predetermined strike price, representing a price below Bitcoin's current market value when the contract begins. If Bitcoin's price falls below the strike price before the expiration date, the holder can exercise the option to sell at the predetermined price. This strategy effectively limits potential losses by offsetting the decline in the holder's Bitcoin holdings, demonstrating how derivatives provide valuable risk management tools and illustrating what underlying assets are in derivatives trading.

What can't be used as an underlying asset in derivatives?

Not every item qualifies as a suitable underlying asset for derivatives. For an asset to be viable, it must be compatible with efficient trading mechanisms and price discovery processes.

Personal property lacks the characteristics necessary for use as an underlying asset in derivatives because it cannot be efficiently traded in standardized markets, making reliable price discovery impossible. Similarly, intangible assets such as patents and brand names present challenges for standardization and valuation in derivative markets.

Perishable goods and difficult-to-store assets, like fresh produce, are also poorly suited as underlying assets. Their limited shelf life and storage complications create practical barriers to their use in derivative contracts, which often span extended timeframes.

Conclusion

Underlying assets in derivatives serve as the cornerstone of the derivatives market, providing the fundamental value upon which complex financial instruments are built. Understanding what an underlying asset is in derivatives is crucial for anyone participating in financial markets. From traditional assets like stocks and bonds to modern innovations like cryptocurrencies and tokenized real-world assets, the range of potential underlying assets continues to expand.

The relationship between derivatives and their underlying assets forms the basis for sophisticated trading strategies, whether for speculation, hedging, or investment purposes. While derivatives offer powerful tools for risk management and market participation, it's essential to recognize that not all assets are suitable as underlying assets—they must be tradeable, standardized, and capable of efficient price discovery.

As financial markets continue to evolve, particularly with the growth of digital assets and decentralized finance, the concept of what underlying assets are in derivatives will continue to adapt, offering new opportunities and challenges for market participants. Understanding this fundamental concept remains essential for navigating the increasingly complex landscape of modern financial instruments.

FAQ

How do derivatives relate to underlying assets?

Derivatives derive their value from underlying assets. The price of a derivative directly depends on the price or performance of its underlying asset, such as stocks or commodities.

What is the underlying asset on a futures option?

The underlying asset on a futures option is the futures contract itself, which represents a specific commodity or financial instrument.

What is an example of a derivative asset?

A futures contract is a common example of a derivative asset. It derives its value from an underlying asset such as commodities, currencies, or stocks.

Which of the following can be an underlying asset of a derivative trade?

Equities, interest rates, currencies, commodities, and bonds can all be underlying assets of derivative trades. Common examples include stock options and futures contracts.