Underlying Asset

Underlying Asset Meaning

The underlying asset is defined as the asset on which the financial instruments such as derivatives are based and the value of the underlying asset is indirectly or directly related to the contracts of the derivatives. They are always traded on the cash markets whereas the derivatives derived from them are traded on the derivative segment or the future markets.

Types of Underlying Assets

Let’s discuss types of the underlying assets.

Types of Underlying Assets

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#1 – Financial Claims or Stocks

The stock is defined as the financial claim which represents 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 with the intent of raising finance to fund business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation.read more or high -growth projects.

#2 – Debt Securities or Bonds

Bond is defined as the 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 defined as the special variant of the mutual fundMutual FundA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks.read more whose benchmark is the underlying index. It is basically 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 investmentPassive InvestmentPassive investing is a strategy used by investors to maximize their returns by avoiding frequent portfolio churning by buying and selling securities and instead buying and holding a diverse range of securities.read more strategies.

#5 – Currency

Currency is defined as the instrument of monetary exchange replacing 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 across the globe is that of United States dollars wherein many countries have performed dollarization to meets its currency requirement equivalent to global standards.

#6 – Commodities

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

Examples of Underlying Asset

Let us understand underlying assets with the help of examples.

Example #1

Example #2 – Practical Application

Underlying Asset

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Underlying Asset Formula

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

d(yn)/dx = n yn-1

Here,

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

Different underlying assets may hold different relationships with the derivatives and hence their formula may vary.

The options present different methods to value itself and 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 value of the underlying asset.

Advantages

Some of the advantages are as follows.

  • Certain variants of underlying assets such as stocks are highly marketable in nature.
  • They have an organized financial market that promotes liquidity and exchange of securities between different parties involved.
  • Many investors use the underlying assets for the purpose of investment and hence 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 very low.

Disadvantages

Some of the disadvantages are as follows.

  • Certain variants of underlying assets can be utilized for speculative purposes. This gives rise to an equal probability of losing money placed in such assets very quickly.
  • Each type of underlying asset poses a specific risk. The stocks and commodities bear investment risk whereas the bond 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 in hand.
  • The performance of the underlying asset has to be monitored periodically to reduce and curb any potential risks associated with these assets.

Limitations

Some of the limitations are as follows.

Important Points

Some of the important points are as follows.

  • The derivatives are the financial innovations whose values can be derived from the underlying assets.
  • The derivatives are employed to perform 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 value of the underlying asset 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.

Conclusion

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

This has been a guide to what is an underlying asset and its meaning. Here we discuss the types of the underlying assets along with examples. We also discuss its advantages, disadvantages, and limitations. You may also learn more about the following articles on derivatives –