Definition
An underlying asset refers to a financial instrument, such as a stock, bond, commodity, currency or index, upon which a derivative’s price is based. It is the asset that the derivative contract owner has the right to buy or sell at a predetermined price in futures and options contracts. Therefore, the performance of an underlying asset directly influences the value of the derivative tied to it.
Key Takeaways
- The term “Underlying Asset” is used within the financial world to describe the actual financial instrument or commodity being traded in a contract. This can include stocks, bonds, currencies, commodities, or futures.
- Options, futures contracts, and other derivatives all get their value from an underlying asset. The price, profit, and loss of these contracts are managed according to the performance of the underlying asset.
- Investors do not necessarily have to physically own the underlying asset to trade in derivatives. This allows for greater flexibility and financial leverage, but a higher level of risk is also involved due to price volatility of the underlying assets.
Importance
The finance term “Underlying Asset” is important because it forms the basis for the values and characteristics of a wide range of financial instruments, such as futures, options, derivatives, and structured products. An underlying asset can be a stock, bond, commodity, currency, or even an index.
Investors often enter into contracts based on the future price of an underlying asset. Potential changes in the value of these assets can directly affect the profitability of their financial investments.
This understanding allows investors to make strategic decisions, manage risk, and seek potential opportunities for profit. Therefore, knowing the performance and volatility of the underlying asset is crucial in financial planning and investment strategies.
Explanation
The purpose of an Underlying Asset in finance is essentially to provide value and serve as a foundational element for derivative instruments, namely futures, options, and contract for difference (CFDs). Underlying assets help create flexibility and diversity in the marketplace, enabling traders and investors to gain exposure to something without having to own it directly. This can help investors manage portfolio risk, hedge against potential downside, or speculate on price movements.
It bridges the gap between investors or traders and commodities or assets that may be otherwise difficult for them to access. Underlying assets are essential in pricing derivative investments.
Essentially, the price and fluctuations of the derivative are directly dependent on the perceived or actual value of the underlying asset. The use of an underlying asset allows for indirect investment, such that profits and losses can be made from market changes, without the need for physical ownership of the asset.
This amplifies the opportunities for investors by broadening their horizons beyond direct investments, potentially providing a means for increased returns based on proficient predictions of market shifts.
Examples of Underlying Asset
Stocks: In the case of a stock option, the underlying asset are the shares of that specific stock. For example, if a company offers stock options to its employees, the employees have the right to purchase the company’s stock at a predetermined price. The underlying asset in this case is the shares of the company’s stock.
Real Estate: In the case of mortgage-backed securities (MBS), the underlying assets could be a pool of home loans taken out by home buyers. If a bank issues an MBS, typically through an investment bank, they are effectively pooling together a group of mortgages that they can then sell off to investors. The investors in the MBS are depending on the cash flow from the amount of mortgage payments to make a chance for return on investment.
Commodities: For commodities futures contracts, the underlying asset could be something like raw materials or agricultural goods. For example, a farmer could sell a futures contract for a certain quantity of wheat to guarantee a price for their crop. The wheat in this case would be the underlying asset. It’s important to note that underlying assets are not limited to these examples and can include bonds, currencies, interest rates, market indexes, and more.
FAQs: Underlying Asset
What is an Underlying Asset?
An underlying asset is a financial instrument (such as stock, bond, commodity, currency, etc.) upon which a derivative’s price is based. It is the primary component that influences the price or the function of the derivative.
What are the types of Underlying Assets?
There are various types of underlying assets, such as equities (stocks), market indices, commodities, currencies, bonds, and interest rates. Other less common types can include other derivatives, real estate, and even indexes of weather conditions or other ecological factors.
How does an Underlying Asset work?
A contract buyer agrees to buy the asset at a specific price on a certain future date (expiry). When that date arrives, the price of the underlying asset is compared to the agreed-upon price. If the underlying asset’s price is above the agreed price, the buyer profits. If not, the seller profits.
Why are Underlying Assets important?
Underlying assets are important because they give derivatives their economic value. Derivatives are essentially bets on future price movements of underlying assets, so without those assets, derivatives would not have any inherent value.
Related Entrepreneurship Terms
- Derivative
- Commodity
- Spot Price
- Equity
- Futures Contract
Sources for More Information
- Investopedia: An extensive online resource on finance and investing. They offer a comprehensive explanation of the term ‘Underlying Asset’.
- Corporate Finance Institute: They provide detailed finance and investment courses and free resources which include information on complex terms like ‘Underlying Asset’.
- The Balance: This site has a dedicated section for personal finance where the term ‘Underlying Asset’ is explained with examples.
- Financial Times: An international daily newspaper with a focus on business and economic news, the Financial Times also offers detailed definitions of financial terms, including ‘Underlying Asset’.
