Underlying Asset

The underlying asset is defined as the asset on which the financial instruments are based, and the value or changes in the value of which leads to the fluctuation in the value of these instruments. In short, the underlying asset’s value is indirectly or directly related to the contracts of the derivatives.

An underlying asset in the derivatives market plays a vital role as the instruments trading there remain influenced by the value of these assets, which thereby determine their value. They are always traded on the cash markets.

• The underlying asset is the foundation upon which financial instruments, such as derivatives, derive their value. 
• Its worth is directly or indirectly tied to the terms of derivative contracts. While these assets are traded in cash markets, the resulting derivatives are exchanged within derivatives or futures markets.
• Examples of underlying assets include financial claims like stocks, debt securities such as bonds, exchange-traded funds (ETFs), market indexes, currencies, and commodities.
• Underlying assets serve as the core elements of derivative contracts, with their performance potentially surpassing or falling short of a nation's economic condition. 

Underlying assets as the fundamental element when it comes to the derivatives market. Whenever an individual buys an instrument, whose value depends on another asset, it becomes the underlying asset of that instrument.

Underlying Assets are basic building blocks for derivatives contracts. Such instruments present both upside and downside risk wherein these instruments can either outperform or underperform the economic condition prevailing in the country. It could be highly speculative and result in immediate value erosion if the positions taken up in such assets are not monitored periodically.

The derivatives are the financial innovations whose values can be derived from the underlying assets.

The derivatives are employed to hedging on the positions taken upon the underlying assets.

It is always advised that an equivalent and opposite position in derivative contracts be maintained corresponding to the position of underlying assets.

Once the position is taken, any change in the underlying asset's value can nullify hedging efforts, and simultaneously the overall position can be transformed into a risky position.

Under such situations, the investor or the hedger can lose money quickly instead of earning steady returns.

Underlying assets exist in different forms. Some of the types of these assets include the following:

#1 - Financial Claims or Stocks

The stock is defined as the financial claim representing proportionate ownership of the investor or holder towards the earnings and overall assets of the issuing business. Stocks can be bifurcated into common and preferred stocks. Stocks are primarily issued to raise finance to fund business operations or high -growth projects.

#2 - Debt Securities or Bonds

A bond is a financial instrument that gives fixed interest payments to the holder. Corporations and government institutions issue bonds to raise finance with the intent to fund business projects or government projects. The holder of such instruments is termed as creditors of debt.

#3 - Exchange Traded Funds

Exchange-traded funds are the special variant of the mutual fund whose benchmark is the underlying index. It is a group of securities encompassed as one unit.

#4 - Market Index

The market index is defined as the collection of securities. The collection could be focused on one specific area of the financial market. These are designed to assess the performance of the financial markets. The index is employed to develop passive investment strategies.

#5 - Currency

Currency is defined as the instrument of monetary exchange replacing the traditional barter system wherein such medium is broadly acceptable in the specific country. Different countries may have different currencies. The most common and popular acceptable currency globally is the United States dollar; many countries have performed dollarization to meet their currency requirement equivalent to global standards.

#6 - Commodities

The commodity is defined as the instrument that is employed in business and commerce-related activities. These items are input for general commerce and the production of business activities. Gold and silver are the most popular commodities traded in the commodities market.

Underlying assets can be expressed in generalized terms of basic mathematical expression as displayed below: –

d(yⁿ)/dx = n y^n-1

Here,

• It is expressed as yⁿ.
• The derivative function would result in a derived value when applied to the underlying asset.
• The derived value is expressed as ny^(n-1)

Underlying assets may hold different relationships with the derivatives; hence, their formula may vary.

The options present different methods to value itself; hence, that specific method can be utilized to determine the value of the underlying asset.

Similarly, the valuation of futures contracts may provide different methods to deduce the underlying asset's value.

Let us consider the following examples to understand what is an underlying asset and how it works:

Example #1

Suppose an underlying asset such as stock A purchased at $50 displays adownside risk. The holder holds one share of stock A. The holder can take up a put option of stock A with a strike price of $50 trading at $2 in the options markets.

A put option is a derivative contract that gives its holder the right to sell the underlying asset at a predefined strike price before the expiration.

The put option gives the right to sell but not the obligation to pursue the selling activity.

The underlying asset for the put option here is the stock A from which the put option is innovated and derived.

Example #2 - Practical Application

Gold is a commodity that is a very popular instrument that can be used both for hedging purposes as well as for investment. The gold can curb the rising levels of inflations and hence curb any potential loss in the value of US dollars.

The dollar holds the title of being an acceptable global currency.

Gold is an underlying asset that never loses its value.

Whenever a dollar collapses in front of rising inflation, gold can be utilized as an alternative investment tool to curb inflation, stop the loss of value, and reduce the potential impacts of a dollar collapse.

The underlying asset price determines the prices of the options and other instruments in the derivatives market. Some of the benefits of these underlying assets include the following:

• Certain variants of underlying assets, such as stocks, are highly marketable.
• They have an organized financial market that promotes liquidity and securities exchange between different parties.
• Many investors use the underlying assets for investment and earn high returns after holding such securities for a considerable investment horizon.
• Since these assets have an organized market, the transaction costs involved in trading such assets are relatively low.

Besides being beneficial to traders and investors, given the upliftment in the prices of the underlying assets, there are certain disadvantages as well, which the market players must be aware of.

Listed below are some of the demerits of underlying assets:

• Certain variants of underlying assets can be utilized for speculative purposes. This gives rise to an equal probability of quickly losing money placed in such assets.
• Each type of underlying asset poses a specific risk. Stocks and commodities bear investment risk, whereas bonds bear default risk and counterparty risk.
• There could be certain types of underlying assets whose derivatives can only be traded and settled on the over-the-counter segments, which in turn give rise to default and counterparty risk if either party does away with its obligation.
•  The underlying asset's performance has to be monitored periodically to reduce and curb any potential risks associated with these assets.
• The value of underlying assets depends on the nation's economic conditions. If the nation is not doing very well economically, then it can cause the value of underlying assets to decrease.
• They are always prone to information asymmetry and adverse selection. Information asymmetry tends to happen when either party involved in the financial transactions hides potential information among themselves that can influence the financial deal. adverse selection happens when the investor chooses bad and underperforming assets for investment.

This has been a guide to an Underlying Asset and its Meaning. Here, we explain the concept with its examples, types, formula, advantages, and disadvantages. You may also learn more about the following articles on derivatives –

• Asset Retirement Obligation
• Real Assets
• What is Market Dynamics?
• Derivatives Contracts Example