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.
#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. 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 fundsExchange-traded FundsAn exchange-traded fund (ETF) is a security that contains many types of securities such as bonds, stocks, commodities, and so on, and that trades on the exchange like a stock, with the price fluctuating many times throughout the day when the exchange-traded fund is bought and sold on the exchange. 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. 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 marketFinancial MarketThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.. 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. 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 dollarizationDollarizationDollarization is the colloquial term for currency substitution, in which a country, either officially or unofficially, either fully or partially accepts a foreign currency as its legal tender for the purpose of enhancing currency stability and reducing the costs of maintaining its own currency. 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.
- Suppose an underlying asset such as stocks A purchased at $50 displays a downside riskDownside RiskDownside Risk is a statistical measure to calculate the loss in a security’s value due to variations in the market conditions. Also, it refers to the uncertainty level of realized returns being much lesser than the anticipated ones. . The holder holds 1 share of stock A. The holder can take up a put option of stock A with a strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market. of $50 trading at $2 in the options markets.
- A put option is a derivative contractPut Option Is A Derivative ContractPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated. that gives its holder the right to sell the underlying asset at a predefined strike price before the date of expiration.
- The put option gives the right to sell but not the obligation to pursue the selling activity.
- The underlying asset for the put option here is the stock A from which put option is innovated and derived.
Example #2 – Practical Application
- Gold is a commodityCommodityA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units. that is a very popular instrument which can be used both for hedging purpose as well as for the purpose of investment. The gold can be used to curb the rising levels of inflations and hence curb any potential loss in the value of US dollars.
- The dollar holds the title of being a global acceptable currency.
- The gold is an underlying asset that never loses its value.
- Whenever a dollar collapses in front of rising inflation, gold can be utilized as an alternative investmentAlternative InvestmentA financial asset that is different from the conventional investment categories such as stocks and cash is referred to as an alternative investment. Private equity, hedge funds, venture capital, real estate/commodities, and tangibles such as wine/art/stamps are all examples of alternative investments. tool to curb inflation, stop the loss of value, and reduce the potential impacts of a dollar collapse.
Underlying Asset Formula
They can be expressed in generalized terms of basic mathematical expression as displayed below: –
d(yn)/dx = n yn-1
- 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.
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.
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.
Some of the limitations are as follows.
- The value of underlying assets is dependent on the economic conditions of the nation. If the nation is not doing very well economically then it can cause the value of underlying assets to be decreased.
- They are always prone to information asymmetryInformation AsymmetryAsymmetric information is the knowledge mismatch that happens when one party secures more information about a product or service than the other party to the transaction. The information failure is often seen when the seller is more informed about a product's condition than the buyer. and adverse selection. Information asymmetry tends to happen when either party involved in the financial transactions hides potential information among themselves that can influence the financial deal. The adverse selection tends to happen when the investor chooses bad and underperforming assets for the purpose of investment.
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 positionsHedging On The PositionsHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market. 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.
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 –