In financial markets, the term “underlying” refers to the security or asset that must be delivered when a derivative contract (such as an option or future) or a warrant is exercised. This underlying asset can be a stock, bond, commodity, currency, or another financial instrument. It is the primary instrument on which the derivative’s value is based.
Characteristics of Underlying Assets
Types of Underlying Assets
- Stocks: Equities representing ownership in a corporation.
- Bonds: Debt instruments issued by corporations or governments.
- Commodities: Physical goods such as gold, oil, or agricultural products.
- Currencies: National money units participating in foreign exchange markets.
- Indices: Aggregated value of a group of assets, like the S&P 500.
Special Considerations
- Volatility: The price fluctuations of the underlying impact the derivative’s value.
- Liquidity: High liquidity guarantees easier entry and exit from positions.
- Market Conditions: Economic, political, and market events can affect the underlying.
Pros and Cons of Underlying Assets
Advantages
- Leverage: Allows investors to control a large position with a smaller initial investment.
- Hedging: Derivatives based on underlying assets can mitigate risks associated with market fluctuations.
- Diversification: Provides opportunities to diversify beyond traditional assets.
Disadvantages
- Risk Exposure: Leverage can amplify losses as well as gains.
- Complexity: Understanding and managing derivatives require sophisticated knowledge.
- Market Sensitivity: Derivative prices can be highly sensitive to changes in the underlying asset’s price.
Examples of Underlying Assets in Action
Example 1: Stock Options
Consider a call option contract on Apple Inc. (AAPL) stock. Here, AAPL stock is the underlying asset. If an investor holds a call option, they have the right (but not the obligation) to purchase AAPL stock at a specified strike price before the contract’s expiration date.
Example 2: Commodity Futures
Crude oil futures contracts are agreements to buy or sell a specified amount of crude oil at a future date. The underlying asset in this case is crude oil. Traders use these contracts to speculate on future oil prices or hedge against price volatility.
Historical Context of Underlying Assets
The use of underlying assets in derivative contracts dates back centuries. The Dojima Rice Exchange in Japan, established in the 18th century, is considered the first organized futures market. Traders there used rice as the underlying asset. Since then, financial markets have evolved to include a wide array of underlying assets, from traditional commodities to complex financial indices.
Related Terms and Definitions
- Derivative: A financial instrument whose value is dependent on the value of an underlying asset.
- Strike Price: The set price at which a derivative contract can be exercised.
- Expiration Date: The date on which a derivative contract becomes void.
- Leverage: The use of borrowed capital to increase the potential return of an investment.
FAQs
What is the significance of an underlying asset?
Can the underlying asset be something other than stocks or bonds?
How can one mitigate risks associated with underlying assets?
References
- Hull, J. (2020). Options, Futures, and Other Derivatives. Pearson.
- Mandelbrot, B., & Hudson, R. L. (2004). The (Mis)behavior of Markets: A Fractal View of Risk, Ruin, and Reward. Basic Books.
Summary
Understanding the concept of the “underlying” asset is crucial for anyone involved in equities and derivatives markets. The underlying asset is the cornerstone upon which derivatives and financial contracts are built, influencing their value and performance. By comprehending its characteristics, pros, cons, and historical context, investors and traders can make informed decisions that leverage the underlying’s potential while mitigating inherent risks.
