The term underlying refers to the fundamental asset, measure, or obligation on which a derivative financial instrument, such as an option or futures contract, is based. Understanding the concept of the underlying is crucial for investors and traders as it directly impacts the value and performance of the derivative instruments.
Historical Context
The concept of underlying assets has been pivotal in the evolution of financial markets. Derivatives trading dates back to ancient civilizations, such as Mesopotamia, where forward contracts for commodities like grains were established. Modern derivatives markets have expanded this to include a wide range of assets.
Types of Underlying Assets
Equities
Equities such as stocks form a common underlying asset for options and futures contracts.
Commodities
Commodities like gold, oil, and agricultural products are often the underlying assets for futures contracts.
Currencies
Foreign exchange markets utilize currency pairs as underlying assets for various derivative products.
Interest Rates
Interest rate derivatives are based on benchmarks like LIBOR (London Interbank Offered Rate).
Market Indexes
Indices like the S&P 500 act as underlying assets for index options and futures.
Key Events in the History of Underlying Assets
- 1973: The Chicago Board Options Exchange (CBOE) is established, becoming the first exchange to list standardized, exchange-traded stock options.
- 1982: The Chicago Mercantile Exchange (CME) launches S&P 500 futures, bringing index-based derivatives into the mainstream.
- 1990s: The rise of electronic trading platforms significantly increases the accessibility and popularity of derivatives.
Detailed Explanations
Impact on Derivative Valuation
The value of a derivative is intrinsically linked to its underlying asset. For instance, the price of a call option on a stock rises if the stock’s price increases.
Risk Management
Investors use derivatives to hedge against potential losses in the underlying asset. For example, a farmer might use futures contracts to lock in prices for crops to manage the risk of price fluctuations.
Mathematical Models
Black-Scholes Model
The Black-Scholes model is used to price European options and includes parameters such as the underlying asset price, strike price, time to expiration, risk-free rate, and volatility.
graph TD;
A[Underlying Asset Price (S)] --> B[Option Value (C)];
B --> C[Volatility (\sigma)];
B --> D[Risk-free Rate (r)];
B --> E[Time to Expiration (T)];
B --> F[Strike Price (K)];
Importance of Underlying Assets
The nature and characteristics of the underlying asset determine the derivative’s performance, risk profile, and suitability for different trading strategies.
Applicability in Various Markets
- Stock Markets: Options on individual stocks or indexes.
- Commodities Markets: Futures on commodities like gold or oil.
- Forex Markets: Currency options and futures.
- Bond Markets: Interest rate swaps based on underlying benchmark rates.
Examples
- Equity Option: A call option on Apple Inc. (AAPL) stock.
- Commodity Future: A futures contract for crude oil delivery.
- Forex Option: An option on the EUR/USD currency pair.
Considerations
Volatility
Higher volatility in the underlying asset typically increases the value of options.
Liquidity
Highly liquid underlying assets usually result in more liquid and efficiently priced derivatives.
Related Terms with Definitions
- Derivative: A financial instrument whose value is dependent on the value of an underlying asset.
- Option: A derivative giving the holder the right, but not the obligation, to buy or sell the underlying asset.
- Future: A derivative obligating the holder to buy or sell the underlying asset at a future date at a predetermined price.
Comparisons
- Options vs. Futures: Options provide a right without an obligation, whereas futures create an obligation.
- Swaps vs. Options: Swaps involve exchanging cash flows or assets, while options grant specific rights without the obligation.
Interesting Facts
- The first formal options market was established in 1973 with the launch of the CBOE.
- Derivatives can be based on almost anything, including weather conditions and economic indexes.
Inspirational Stories
George Soros, through strategic use of currency options, is renowned for “breaking the Bank of England,” making a significant profit by betting against the British pound in 1992.
Famous Quotes
“The greatest risk in life is to wait for and depend upon others for your security and success.” — Denis Waitley
Proverbs and Clichés
- “Don’t put all your eggs in one basket.” (Diversification in using underlying assets)
- “High risk, high reward.” (The nature of derivatives trading)
Expressions, Jargon, and Slang
- Delta: Sensitivity of an option’s price to the underlying asset’s price.
- Theta: Rate of decline in the value of an option due to the passage of time.
- Gamma: Rate of change in Delta for a change in the underlying price.
FAQs
Q1: What is an underlying asset?
A1: It is the asset, measure, or obligation on which a derivative instrument is based.
Q2: How does the underlying asset affect a derivative?
A2: Changes in the underlying asset’s price or value directly impact the value of the derivative.
Q3: Can an underlying asset be anything other than a stock or commodity?
A3: Yes, underlying assets can include indexes, interest rates, currencies, and more.
References
- Hull, J. C. (2012). Options, Futures, and Other Derivatives. Pearson.
- Black, F., & Scholes, M. (1973). The Pricing of Options and Corporate Liabilities. Journal of Political Economy, 81(3), 637-654.
- CME Group. (2023). Futures and Options Markets Overview.
Summary
The concept of the underlying is fundamental to understanding the mechanics of derivative markets. Whether it is equities, commodities, currencies, or interest rates, the characteristics of the underlying asset directly influence the value, risk, and trading strategies associated with derivatives. From historical developments to contemporary applications, the underlying remains a critical component for financial instruments and market participants.
