What is an Underlying Asset?

In finance and investments, the term underlying asset is quite common. It denotes the principal financial instrument or security that is the basis for a derivative contract. Acting as the bedrock or core value, the underlying asset establishes the price or performance of a derivative and the fundamental value that dictates the price of the financial instrument.

Underlying Asset Meaning

An underlying asset refers to a specific financial instrument, physical asset, or index that forms the basis of a derivative contract or investment product. It serves as the foundation upon which the value of a derivative or other financial instrument is derived. Underlying assets can be diverse and encompass various financial instruments such as bonds, stocks, currencies, indices and more.

Characteristics of Underlying Assets

1. Ownership: The underlying asset represents actual ownership or a claim on an asset. For example, in the case of stocks, the underlying asset would be the shares of a particular company that the derivative contract or investment is based on.

2. Value Determination: The value of a derivative or investment product is derived from the underlying asset. Any change in the underlying asset's value will impact the value of the derivative or investment product accordingly.

3. Contractual Agreement: The underlying asset forms the basis of a contractual agreement between two parties. The terms and conditions of the derivative contract or investment product are directly linked to the underlying asset.

Underlying Asset Example

To better understand how underlying assets function, let's examine an illustrative example. Imagine that the shares of Company XYZ are actively traded in stock markets. Currently, the stock's price is Rs. 1400 per share. Additionally, there is a call option contract for this stock with a strike price of Rs. 1420, expiring in one month.

Now, let's consider a scenario where Company XYZ releases its quarterly results, revealing a remarkable 50% increase in profits. As a result, the share price rises to Rs. 1500. This increase in the underlying asset's value leads to a proportional rise in the profits generated from the call options contract. In this case, the profit per share would be Rs. 80.

Conversely, it is also possible for a company to report a loss in its quarterly results. Suppose the share price drops to Rs. 1300 from its pre-announcement level. Consequently, the price of the call options contracts will experience a significant decline. This example highlights how the underlying asset's price substantially influences the value of the derivative contracts.

Types of Underlying Asset

1. Stocks: In the context of options or futures contracts, shares of individual companies act as the underlying assets. The value of the derivative depends on the price movements of these stocks.

2. Commodities: Assets such as gold, silver, oil, natural gas, agricultural products, and more can serve as underlying assets. Derivatives like futures contracts often derive their value from the price fluctuations of these commodities.

3. Indices: Stock market indices, such as the BSE 30 or the Nifty 50, act as underlying assets for index-based financial products like index funds, exchange-traded funds (ETFs), or futures contracts.

4. Currencies: In the foreign exchange market, currencies represent underlying assets. Currency options and forex contracts derive value from the exchange rate fluctuations between different currency pairs.

5. Bonds: Bonds are financial instruments utilized by public and private entities to raise capital. They are classified as fixed-income securities with relatively low levels of risk. Various types of bonds exist, including government bonds, treasury bills, corporate bonds, and infrastructure bonds.

Importance of Underlying Assets

1. Pricing and Valuation: The value of derivatives and investment products depends on the movements and characteristics of their underlying assets. Traders and investors need to analyze and evaluate the underlying asset's behavior to make informed decisions.

2. Risk Management: By understanding the underlying asset, investors can assess the risks associated with derivatives or investment products. Changes in the underlying asset's value can help gauge potential gains or losses.

3. Market Insights: Underlying assets provide insights into specific markets. By studying the underlying assets, investors can better understand the factors influencing the market and make more informed predictions.

In Conclusion

An underlying asset forms the foundation of derivative contracts and investment products. It represents the actual ownership or claim on an asset and determines the value and characteristics of these financial instruments.

From commodities and stocks to indices and currencies, underlying assets are diverse and play a vital role in the financial markets. By comprehending the concept of underlying assets, investors can enhance their decision-making processes and navigate the complexities of various financial instruments more effectively.