What is Underlying?
Underlying, in the context of equity trading, refers to the stock that must be delivered when a financial instrument like a warrant is exercised, or a convertible bond is converted into common stock.
The price of the underlying asset plays a pivotal role in determining the value of derivative securities. As such, changes in the price of the underlying stock affect the price of associated derivatives like warrants and convertibles.
Key Takeaways
- Underlying Assets: These are the foundational assets that must be delivered when certain financial instruments are exercised.
- Role in Derivatives: The price of derivatives is directly related to the value of their underlying assets. A shift in the underlying’s price consequently alters the derivative’s value.
- Range of Underlyings: These can include stocks, commodities, indices, interest rates, or even other derivatives.
- Convertible Securities: For such instruments, the underlying is the stock that may be swapped for the original bond or preferred share.
- Volatility: In general, underlying assets experience less volatility compared to their derivatives.
Understanding Underlying Assets
Underlying assets apply to various forms of equity and derivatives contracts. These contracts leverage the price or value of a base asset—often a stock. If the stock’s price increases, the value of the derivative may also change accordingly.
In the realm of futures contracts, the underlying could be commodities such as oil, gold, or wheat. Market disruptions impacting these commodities would subsequently influence the related futures.
Convertibles also rely on an underlying asset and may incorporate derivative-like characteristics. Such instruments, under specified conditions, can be repaid in company shares rather than cash, making the shares the underlying asset.
Interestingly, underlying assets are not confined solely to tangible assets; they can also be benchmarks, interest rates, or even other derivatives.
Financial Derivatives – The Core of Underlying Assets
The term “underlying” predominantly appears in discussions of derivatives. One popular type of derivative is options trading, where traders bet on the future price movements of stocks or commodities. Meeting the contract’s terms allows them to profit.
However, not all derivatives are backed by physical assets. Benchmark indices, interest rates, or vital financial metrics can also qualify as underlying assets. Changes in these parameters can affect the value of derivatives tied to them.
A notable example is interest rate swaps that often use the secured overnight financing rate (SOFR) to calculate cash flows. When SOFR rates rise or fall, the value of the corresponding swaps adjusts reflectively.
Weighing the Pros and Cons of Underlying Assets
Advantages
- Liquidity and Volume: Derivatives trading channels additional liquidity into underlying spot markets, which could otherwise lack such benefits.
- Organized Markets: Underlying assets in derivative contracts benefit from structured trading environments.
- Stability: Typically, underlying assets exhibit less volatility compared to their derivatives.
Disadvantages
- Speculative Risks: Derivative markets can inadvertently impact the value of underlying assets through excessive speculation.
- Inherent Risks: Each underlying asset carries specific risks which can impact the derivatives tied to it.
Example: Understanding Underlying Through Calls and Puts
One common derivative example includes call and put options. In a call option, the owner has the right—but not the obligation—to purchase a stock at a predetermined strike price.
Imagine Company A’s stock is trading at $5, and your call option has a strike price of $3. If the stock price is trending above $3, say at $5, then the call option gains value (worth $2 theoretically). Here, the underlying asset is the stock trading at $5, and the derivative is the call option priced at $2.
Conversely, a put option grants the owner the right to sell a stock at a set strike price. If Company A’s stock is priced at $5 and your put option’s strike price is $7, with the stock price trending down to $5, the derivative would be worth (trading $2 theoretically). In this instance, the underlying stock price remains $5.
Both call and put options depend significantly on the price of the underlying asset—in this case, Company A’s stock.
What Happens When the Price of an Underlying Asset Increases?
Changes in the underlying asset’s price generally cause proportional changes in their derivatives. For example, a call option confers the right to buy a stock at a specific price. If the stock is priced $3 above the strike price, the option could be valued at $3. Conversely, if it falls below the strike price when the option expires, its value would drop to zero.
Are Shares Considered Underlying Assets?
Yes, shares can serve as underlying assets, especially in derivative contracts such as call and put options, which are bets on future stock prices. Convertible debt instruments also use shares as underlying assets—they can convert into equity under specific conditions.
What Are the Primary Underlying Assets?
Common underlying assets include stocks, commodities, bonds, and currencies. There are also derivatives with less tangible underlyings, such as interest rates and benchmark indexes.
Related Terms: warrants, convertible bonds, futures, options, interest rates.
