Underlying Asset (Derivatives): Definition, Mechanics, and Examples

An exploration of underlying assets in derivatives, including their definition, how they work, and practical examples.

An underlying asset is a financial instrument whose value determines the price of a derivative. Derivatives are contracts that derive their value from the performance of an underlying entity such as an asset, index, or interest rate.

How Underlying Assets Work

Definition and Mechanics

An underlying asset can be any financial product—stocks, bonds, commodities, currencies, interest rates, or market indexes. Derivatives such as options, futures, and swaps depend on these assets for their value. For instance, a stock option derives its value from the stock of a specific company.

$$ \text{Price of Derivative} = f(\text{Underlying Asset Price}) $$

Types of Underlying Assets

• Equities: Stocks of publicly traded companies.
• Indices: Market indexes like the S&P 500 or Dow Jones Industrial Average.
• Commodities: Physical goods such as gold, oil, and agricultural products.
• Currencies: Exchange rates between different national currencies.
• Interest Rates: Benchmarks like the LIBOR or federal funds rate.

Special Considerations

When trading derivatives, understanding the characteristics of the underlying asset is crucial. Factors influencing the underlying asset include market volatility, economic indicators, and geopolitical events.

Examples of Underlying Assets

Stock Options

A stock option for Apple Inc. (AAPL) is an example of a derivative whose underlying asset is Apple’s common stock. The option’s price is based on AAPL’s share price.

Commodity Futures

A futures contract for crude oil takes crude oil as its underlying asset. Traders speculate on the future price of this commodity.

Currency Swaps

A currency swap might involve exchanging interest payments in USD and EUR, based on the underlying exchange rate between these two currencies.

Historical Context

Evolution of Underlying Assets

Derivatives have ancient origins, with rice futures traded in Japan in the 17th century. Modern derivatives markets expanded in the 1970s with the advent of financial engineering.

Applicability and Comparisons

Uses in Finance

Investors use derivatives for hedging, speculation, and arbitrage:

• Hedging: Protecting against price movements in underlying assets.
• Speculation: Betting on future price movements without holding the underlying asset.
• Arbitrage: Exploiting price differences between markets.

Related Terms

• Derivative: A contract based on an underlying asset.
• Option: A derivative giving the right but not the obligation to buy or sell the underlying asset.
• Future: A standardized contract to buy or sell the underlying asset at a future date.

FAQs

What happens if the underlying asset's value fluctuates widely?

Wide fluctuations can significantly affect the derivative’s value, leading to either large profits or substantial losses.

Can derivatives exist without an underlying asset?

No, by definition, derivatives must derive their value from an underlying asset.

Are all underlying assets tangible?

No, underlying assets can be intangible such as indexes or interest rates.

References

1. Hull, J. C. (2017). “Options, Futures, and Other Derivatives.”
2. Black, F., & Scholes, M. (1973). “The Pricing of Options and Corporate Liabilities.”

Summary

In conclusion, an underlying asset is pivotal in determining the price and utility of derivative instruments. Investors and traders must thoroughly understand the mechanics and implications of underlying assets to navigate financial markets effectively.