Underlying: Asset, Measure, or Obligation Base for Derivatives

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.

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.

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.

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.

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.

Related Terms

• 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.

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.