A Guide to Understanding Underlying Assets in Derivatives

Explore the essential role of underlying assets in the world of derivatives, including stock options, futures, and more.

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.


Get ready to put your knowledge to the test with this intriguing quiz!

--- primaryColor: 'rgb(121, 82, 179)' secondaryColor: '#DDDDDD' textColor: black shuffle_questions: true --- ## What does the term "underlying asset" refer to in financial markets? - [ ] The physical location of a stock exchange - [x] The financial instrument on which a derivative's price is based - [ ] A financial institution that issues stocks and bonds - [ ] The fundamental components of an insurance policy ## Which of the following financial instruments can have an underlying asset? - [ ] Bonds - [ ] Stocks - [ ] Commodities - [x] All of the above ## An underlying asset in an options contract is most commonly what? - [ ] Real estate property - [x] Stock or ETF - [ ] Life insurance policy - [ ] Company debt ## Why are underlying assets important in derivative trading? - [ ] They eliminate the need for speculators - [ ] They provide guaranteed profits - [x] They determine the value of the derivative - [ ] They are responsible for issuing dividends ## In a commodity futures contract, what is the underlying asset? - [x] The physical commodity agreed upon for future delivery - [ ] Currency pair - [ ] Company stocks - [ ] Government bonds ## A stock option’s value is derived from its underlying asset. What does this refer to? - [ ] The strike price - [ ] The exercise date - [ ] The premiums - [x] The stock itself ## Which of these is NOT an example of an underlying asset? - [ ] A currency pair in a forex contract - [ ] An index for an index option - [x] A company manager - [ ] A bond in a bond option ## For a call option, which of the following best describes the underlying asset? - [ ] It is the option price - [ ] The total potential profit - [x] The asset that the holder has the right to buy - [ ] The timeframe until expiration ## How do underlying assets relate to ETFs? - [ ] They have no connection with ETFs - [x] ETFs are composed of underlying assets such as stocks, bonds, or other securities - [ ] ETFs only track company performance - [ ] ETFs are substitutes for underlying assets ## What happens to the value of a derivative if the price of the underlying asset changes? - [x] The value of the derivative can change - [ ] The value of the derivative stabilizes - [ ] The value of the derivative is unaffected - [ ] The derivative gains intrinsic value