Underlying Assets: The Foundation of Derivatives
Underlying assets are the financial assets upon which a derivative’s price is based. Options, for instance, are a type of derivative with prices based on their underlying assets. A derivative is a financial instrument whose value is derived from a different asset.
The Significance of Underlying Assets
Underlying assets imbue derivatives with their value. For example, an option on stock XYZ gives the holder the right to buy or sell XYZ at the strike price until expiration. The underlying asset for this option is the stock of XYZ. Option chains for numerous stocks are widely available but not universal.
An underlying asset serves to identify the item within a contract that endows the agreement with value. This asset fortifies the security involved in the agreement, and the contracting parties agree to exchange it as part of the derivative contract.
Unpacking Derivative Contracts
The price of options or futures contracts is derived from the price of an underlying asset. In an option contract, the writer must either buy or sell the underlying asset to the buyer on the specified date at the agreed-upon price. The buyer isn’t obliged to purchase the underlying asset but can exercise their right should they choose to. If the option is approaching its expiration and the underlying asset hasn’t shown favorable movement, the buyer can let it lapse and only lose the amount initially paid for the option.
Futures contracts posit obligations on both the buyer and the seller. The seller agrees to provide the underlying asset upon contract expiry, and the buyer agrees to purchase the asset at the same point. The payment is set at the futures contract’s entered price. Despite physical asset transfers being uncommon among retail traders and hedge funds, many close out their positions before expiration to take advantage of price shifts.
Futures qualify as derivatives as their value hinges on the price movements of the underlying asset, such as oil futures reflecting oil price movements.
Key Insights
- Underlying assets represent the source of value for derivatives.
- Accurately gauging the value of an underlying asset aids traders in deciding their strategies regarding the derivatives.
Example of an Underlying Asset
In stock options scenarios, the underlying asset is the stock itself. For instance, a stock option permitting the purchase of 100 shares of Company X at $100 relies on the stock of Company X as its underlying asset. The underlying asset’s value determines the option’s worth up until its expiration, and fluctuating values of the asset directly impact the option’s value. Traders continually assess the underlying asset’s real-time value to decide if it’s beneficial to exercise the option.
Underlying assets can also span across currencies or market indexes like the S&P 500. In stock indexes, the underlying asset comprises the ordinary stocks within the index.
Related Terms: options, futures, market index, hedge funds, derivative market.
