Underlying Assets: Definition, Types, and Examples

Understanding underlying assets is crucial for grasping the concept of financial derivatives. This article explores the definition, types, and examples of underlying assets, providing a comprehensive overview of this fundamental aspect of finance.

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 asset, index, or entity. Common types of derivatives include options, futures, forwards, and swaps. These financial tools are used for trading, speculation, hedging, and price discovery, although they can also present risks such as complexity and leverage.

What are underlying assets?

An underlying asset is the foundation upon which a derivative contract is built. It's the asset whose value determines the value of the derivative. The price fluctuations of the underlying asset directly impact the derivative's value. Two primary types of derivatives 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 certain timeframe. Futures contracts, on the other hand, represent an obligation to buy or sell the specified asset at a predetermined price on a future date.

Types of underlying assets

A wide variety of 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 options, futures, swaps, and forwards.
4. cryptocurrencies: Digital currencies like Bitcoin can be the basis for crypto derivatives.
5. Indices: These track the performance of groups of securities and are used in futures, options, and swaps.
6. Real-world items: Tangible assets like paintings or real estate can be tokenized as NFTs.
7. Exchange-traded funds (ETFs): These can be used in ETF options and index futures.

Interestingly, even unconventional elements like 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 Bitcoin as an underlying asset. A Bitcoin holder might purchase a put option to sell 10 BTC at a specific price within a certain timeframe, paying a premium. This option serves as a hedge against a potential price drop, allowing the holder to sell at the predetermined price if Bitcoin's value falls below the specified amount during the contract period.

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 trading mechanisms. Personal property, intangible assets like patents and brands, and perishable goods are generally not suitable as underlying assets due to difficulties in efficient trading and price discovery.

Conclusion

Understanding underlying assets is fundamental to grasping the complexities of financial derivatives. From traditional assets like stocks and bonds to modern digital assets like cryptocurrencies, underlying assets form the backbone of derivative contracts. As the financial world continues to evolve, the range of potential underlying assets expands, offering new opportunities and challenges in the realm of financial derivatives.

FAQ

What exactly is an underlying asset?

An underlying asset is a real financial asset that determines the value of a derivative. It can be stocks, bonds, commodities, or currencies.

What is an example of an underlying?

An example of an underlying is a stock in options trading. Other examples include commodities, currencies, or indices in futures contracts.

Do you own the underlying asset?

No, you don't own the underlying assets directly. You own shares in the fund that holds these assets.

What is underlying in simple terms?

Underlying is the asset or security tied to a financial instrument. It's what must be delivered when a contract or warrant is exercised, applying to both equities and derivatives.