Underlying Asset

Underlying Asset

In financial circles, the world is driven by assets. The goal is to accumulate the most valuable assets to create and maintain long-term wealth. To understand the key principle of wealth creation, traders should know everything about underlying assets and their role in portfolio management.

What is an underlying asset?

The underlying asset is the basic security or investment vehicle on which derivatives operate. Underlying assets can be individual securities, like stocks or bonds, or groups of securities, like in an index fund.

A derivative is a financial contract between two or more parties based on the current or future value of the underlying asset. If we consider widely used markets, derivatives can take many forms, such as futures, stock options, swaps, and warrants. These are high-risk, high-reward instruments. Investors use them to bet on the future value of the underlying asset. Another purpose of derivatives is to hedge against other investments, seeking to reduce investment risk. Finally, derivatives are also speculative instruments, which can increase investment risk.

This is where the underlying assets come into play. To make the best bets on derivatives, investors tend to either hedge risk or increase it by speculative activities in high-risk areas such as options and futures. The underlying assets that enable these bets are critical to the process of investing in derivatives.

Types of Underlying Assets

     1. Financial claims or stocks

A stock is a financial claim that represents the investor's or holder's proportionate ownership of the income and total assets of the issuing company. Stocks are primarily issued to raise finance to fund business operations or high-growth projects. Stocks can be ordinary or preferred.

     2. Debt securities or bonds

A bond is a financial instrument that gives the holder fixed interest payments. Corporations and government institutions issue bonds to raise funds to fund business or government projects. Holders of such instruments are called debt creditors.

     3. Exchange Traded Funds

Exchange-traded funds are special types of mutual funds benchmarked by an underlying index. In fact, this is a group of securities combined into one unit.

     4. Market Index

A market index is a collection of securities, which focuses on one specific area of ​​the financial market. Indices evaluate the effectiveness of financial markets, and they help develop passive investment strategies.

     5. Currency

A currency is an instrument of money exchange that replaced the traditional barter system. Different countries may have different currencies. The most common and popular currency accepted worldwide is the US dollar.

     6. Commodities

A commodity is an instrument that is used in business and commercial activities. These items represent inputs to general trade and manufacturing business activities. Gold and silver are the most popular commodities traded on the commodity market.

Example of Underlying assets

One of the most famous and widely traded financial derivatives is stock options. Stock options are derivatives whose value is based on the underlying asset, namely the actual stock. For example, a call option on a share gives the buyer the right to buy the share at a specified price (strike price) until the option expires.

Obviously, the value and price of the option depend on the real stock price. For stocks trading at $60 per share, a call option on a share with an exercise price of $50 would be worth a minimum of $10 per share because the call option gives the option holder the right to buy a $60 share for only $50.

Stocks, bonds, commodities, such as gold, oil or cotton, interest rates, market indices, and currencies are the underlying assets that have influenced the creation of many financial derivatives. In addition to options, the most popular derivatives include forward contracts, credit default swaps (CDS), and collateralized debt obligations (CDOs).

Derivative financial instruments are commonly used to manage risk in investing. For example, an investor who owns multiple shares of a given stock can hedge their investment in the underlying asset—the stock—using derivative stock options.

The concept of underlying assets is important for investment speculators who may seek profit from arbitrage trading in underlying assets and derivatives, i.e. trades designed to profit from temporary market differences between the price of the underlying asset and the price of the derivative, based on this asset.

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2022-04-20 • Updated

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