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 of their role in the financial world.

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 based on the performance of an underlying asset, index, or entity. Common types of derivatives include options, futures, forwards, and swaps. These instruments are used for trading, speculation, hedging, and price discovery, although they come with potential risks such as complexity and leverage.

What are underlying assets?

An underlying asset is the foundation upon which a derivative contract derives its value. The price fluctuations of the underlying asset directly influence the value of the derivative. Two primary types of derivatives are options and futures:

1. Options: These contracts give the buyer the right, but not the obligation, to buy or sell an asset at a specified price within a set timeframe.

2. Futures: These contracts obligate the buyer or seller to transact an asset at a predetermined price on a specific future date.

Types of underlying assets

Various assets can serve as underlying assets for derivatives. Some 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: These are used in currency derivatives for speculation or hedging against exchange rate changes.

4. cryptocurrencies: Digital assets can be the basis for crypto derivatives.

5. Indices: These track the performance of baskets of securities and are used in various derivative contracts.

6. Real-world items: Tangible assets like paintings or real estate can be tokenized as NFTs and traded.

7. Exchange-traded funds (ETFs): These publicly traded funds can underlie ETF options and index futures.

Interestingly, even weather conditions have been used as underlying assets for derivatives, particularly in industries sensitive to weather fluctuations.

Example of an underlying asset

To illustrate the concept, let's consider a popular cryptocurrency as an underlying asset. A holder of this digital currency who is generally optimistic about its future but wants to protect against a potential crash might purchase a put option. This option gives them the right to sell a specific amount of the cryptocurrency at a predetermined price within a set timeframe, effectively hedging against significant price drops.

What can't be used as an underlying asset?

Not all items qualify as underlying assets. To be suitable, an asset must be compatible with efficient trading and price discovery. Personal property, intangible assets like patents and brands, and perishable or hard-to-store items generally don't work well as underlying assets for derivatives.

Conclusion

Understanding underlying assets is fundamental to comprehending the world of financial derivatives. From traditional assets like stocks and bonds to more modern options like cryptocurrencies, underlying assets form the backbone of derivative contracts. By grasping this concept, investors and financial professionals can better navigate the complexities of derivative markets and make more informed decisions in their financial strategies.

FAQ

What is an underlying asset with example?

An underlying asset is the financial instrument or commodity that a derivative is based on. For example, a stock option's underlying asset is the company's stock, which determines the option's value.

What is another name for an underlying asset?

Another name for an underlying asset is the underlying security. It refers to the actual asset that gives value to a financial instrument, such as gold in a gold ETF.

What exactly is an underlying asset?

An underlying asset is the financial instrument or commodity that a derivative contract is based on. It determines the derivative's value and price movements.

What is an example of an underlying stock?

An example of an underlying stock is Apple Inc. for an option contract based on Apple shares. The stock itself is the asset upon which the derivative is built.