Underlying Assets: Definition, Types, and Examples

Understanding the concept of underlying assets is crucial for grasping the complexities of financial derivatives. This article explores the definition, types, and examples of underlying assets, providing a comprehensive overview for those interested in finance and investment.

What is a derivative in finance?

Before delving into underlying assets, it's essential to understand derivatives. A derivative is a financial instrument whose value is derived from the performance of an underlying entity. This entity can be an asset, index, or entity. Derivatives are used for various purposes, including trading, speculation, hedging, and price discovery. Common types of derivatives include options, futures, forwards, and swaps.

What are underlying assets?

An underlying asset is the financial instrument or asset upon which a derivative's value is based. The price fluctuations of the underlying asset directly impact the value of the derivative contract. Two primary types of derivatives that rely on underlying assets are options and futures contracts.

Options give the buyer the right, but not the obligation, to buy or sell an asset at a specified price within a set timeframe. Futures contracts, on the other hand, create an obligation to buy or sell the asset at a predetermined price on a specific future date.

Types of underlying assets

There is a wide variety of underlying assets used in derivative contracts. Some of the most common types include:

1. Shares: Corporate stocks are frequently used in options, futures, and equity swaps.
2. Bonds: Government and corporate bonds often underlie bond options, futures, and interest rate swaps.
3. Currencies: Foreign exchange derivatives use currencies as underlying assets.
4. cryptocurrencies: Digital currencies can be used in crypto derivatives.
5. Indices: Market indices serve as underlying assets for index futures and options.
6. Real-world items: Tangible assets like real estate or art can be tokenized as NFTs.
7. Exchange-traded funds (ETFs): These funds can be used in ETF options and index derivatives.

Interestingly, even unconventional items like weather conditions have been used as underlying assets in specialized derivatives.

Example of an underlying asset

To illustrate the concept, let's consider a popular cryptocurrency as an underlying asset. A crypto holder might purchase a put option to protect against potential price drops. For instance, they could buy a three-month option contract to sell a certain amount of the cryptocurrency at a specific price, even if the market price falls below this level. This strategy allows the holder to hedge against significant losses while maintaining the potential for gains if the price rises.

What can't be used as an underlying asset?

While many items can serve as underlying assets, there are limitations. Assets that cannot be efficiently traded or lack a mechanism for price discovery are unsuitable. Examples include:

1. Personal property
2. Intangible assets like patents or brands
3. Perishable goods
4. Items that are difficult to store or transfer

Conclusion

Understanding underlying assets is fundamental to comprehending the world of derivatives and financial markets. From traditional assets like stocks and bonds to more modern options like cryptocurrencies, underlying assets form the foundation upon which complex financial instruments are built. As financial markets continue to evolve, the range of potential underlying assets is likely to expand, offering new opportunities and challenges for investors and financial professionals alike.

FAQ

What exactly is an underlying asset?

An underlying asset is the financial instrument or commodity that a derivative contract is based on. It can be stocks, bonds, currencies, commodities, or market indexes.

What is an example of an underlying?

An example of an underlying asset is Bitcoin for Bitcoin futures contracts. Other examples include stocks for stock options, or commodities like gold for gold futures.

How do you choose the right underlying asset?

Research market trends, analyze historical performance, assess liquidity, and consider the asset's long-term potential. Diversify your portfolio and align choices with your investment goals and risk tolerance.