In the world of finance, understanding the concept of underlying assets is essential for both novice and seasoned investors. Whether you’re trading stocks, bonds, or complex financial derivatives, underlying assets play a crucial role in determining the value and performance of your investments. But what exactly are underlying assets, and how do they work? Let’s break it down.
What is Underlying Asset?
An underlying asset is a financial asset that determines the value of a derivative instrument. In simpler terms, it is the asset upon which a derivative contract is based. For example, in an options contract, the price of the option is derived from the price of the underlying asset, such as a stock, bond, or commodity.
Types of Underlying Assets
There are several types of underlying assets, each with its own characteristics and risks. Here are the most common types:
Stocks (Equities)
- Definition: Stocks or equities represent ownership in a company. They are one of the most common underlying assets for derivatives like options and equity futures.
- Example: If you buy a call option on HDFC Bank, the stock of HDFC Bank is the underlying asset.
Bonds
- Definition: Bonds are debt securities issued by governments, municipalities, or corporations. They can serve as underlying assets for bond options, bond futures, or interest rate swaps.
- Example: A futures contract based on U.S. Treasury bonds uses those bonds as the underlying asset.
Commodities
- Definition: Commodities include physical goods like gold, oil, natural gas, agricultural products, and metals. They are commonly used as underlying assets in commodity futures and options.
- Example: Crude oil futures contracts use the price of crude oil as the underlying asset.
Currencies (Forex)
- Definition: Currencies are another popular underlying asset, particularly in foreign exchange (Forex) markets. Currency pairs like EUR/USD are used in Forex options and futures.
- Example: In a currency option, the underlying asset could be the exchange rate between the U.S. dollar and the euro.
Indices
- Definition: An index represents a portfolio of stocks or bonds and is often used as an underlying asset in index options and index futures.
- Example: The NIFTY 50 index is a common underlying asset for index options and futures.
Interest Rates
- Definition: Interest rates themselves can be underlying assets in interest rate derivatives like swaps and options.
- Example: A contract based on the LIBOR rate uses that rate as the underlying asset.
Real Estate
- Definition: Real estate can also serve as an underlying asset in real estate derivatives, which are often used to hedge against property price changes.
- Example: A real estate index tracking commercial property prices can be the underlying asset for a real estate futures contract.
How Underlying Assets Work in Financial Derivatives?
To understand how underlying assets work, you need to grasp the concept of derivatives. A derivative is a financial contract whose value is dependent on the price of an underlying asset. When you trade derivatives, you’re not directly buying or selling the asset itself. Instead, you’re entering into a contract that derives its value from that asset.
Futures Contracts:
A futures contract is an agreement to buy or sell an underlying asset at a predetermined price on a specific date in the future. For instance, crude oil futures are based on the underlying asset of crude oil.
Learn Details: What is Future Trading and How to Trade Futures?
Options Contracts:
An option gives the holder the right, but not the obligation, to buy or sell the underlying asset at a set price before the option expires. Stock options are a common example, where the underlying asset is the company’s stock.
For example, if you purchase a stock option, you’re buying the right (but not the obligation) to buy or sell that stock (the underlying asset) at a specific price within a set period. The value of the option depends on the price movements of the underlying stock.
The value of a derivative contract is closely tied to the performance of its underlying asset. Here’s how the process typically works:-
Price Determination: The price of the derivative is directly linked to the price of the underlying asset. For example, in an option contract, the value of the option (premium) depends on factors like the current price of the underlying asset, the strike price, and the time to expiration.
Risk Management: Investors and traders use derivatives based on underlying assets to manage risk. For instance, if a farmer expects the price of wheat (a commodity) to drop in the future, they may use a wheat futures contract to lock in a price now, protecting themselves against the price decline.
Speculation: Traders often use derivatives to speculate on the price movement of the underlying asset. For example, an investor might buy a call option on a stock, expecting the stock’s price to rise. If the price does increase, the investor can exercise the option to buy the stock at a lower price and profit from the difference.
Leverage: Derivatives allow investors to gain exposure to underlying assets with a smaller initial investment compared to directly purchasing the asset. This leverage amplifies potential gains, but it also increases risk.
Hedging:-Hedging involves using derivatives to offset potential losses in an investment portfolio. For example, an investor holding a large position in a stock might buy a put option (which gains value as the stock price falls) to protect against a potential decline in the stock’s price.
Indian Stock Market Perspective
In the Indian stock market, futures and options are the most commonly traded derivatives.
Futures
A futures contract is a standardized agreement where two parties commit to buying or selling an asset at a set price and quantity on a specific future date. The value of this contract is derived from the underlying asset. Commonly traded futures include those based on stocks and indices, such as Reliance Industries Ltd futures (based on Reliance Industries Ltd shares) and Nifty50 futures (based on the Nifty50 index).
Indian stock markets offer trading in a series of monthly and weekly futures contracts. Due to exchange regulations, futures contracts are limited to a maximum of three months and are categorized based on their expiry dates:
- Near month
- Next month
- Far month
For stocks, futures contracts expire monthly, with the expiry date typically set for the last Thursday of the month. If the last Thursday is a holiday, the contract will expire and be settled on the previous working day.
To trade in futures, an initial margin is required. You can use the margin calculator to determine the margin needed for a position.
Options
In addition to futures, options are another widely traded derivative in the Indian stock market.
An option buyer has the right, but not the obligation, to purchase (call option) or sell (put option) the underlying security at a predetermined price on or before a specific date. Conversely, an option seller is obligated to fulfill the terms of the contract if the option buyer decides to exercise their right. Call options allow buying, while put options allow selling.
There are two types of options: call options and put options. These can be based on stocks or indices. Examples include:
- Stocks: HDFC Bank, TCS, ITC, INFY HCL Technologies, etc.
- Indices: Nifty50, Bank Nifty, Fin nifty, Sensex.
Stock options only have monthly expiries, which occur on the last Thursday of each month. However, index options and futures can have both weekly and monthly expiries. Weekly options expire every Thursday.
Like futures, option contracts also follow a series of three successive calendar months, categorized as current month, near month, and far month.
Weekly index options that expire on Thursdays are referred to as near week contract, next week contract, and far week contract.
Why Underlying Assets Matter to Investors?
The underlying asset is the cornerstone of any derivative investment. It directly impacts the derivative’s value and, consequently, the potential gains or losses for investors. Understanding the nature of the underlying asset helps investors make informed decisions about their investment strategies and manage risks more effectively.
Valuation of Underlying Assets
The valuation of underlying assets is influenced by various factors, including supply and demand, market conditions, and economic indicators. The market price of the underlying asset often fluctuates, which in turn affects the price of derivatives linked to it.
Market Price vs. Intrinsic Value
The market price is the current price at which the underlying asset is traded, while intrinsic value refers to the true value based on fundamental analysis. Understanding this difference is crucial for evaluating investment opportunities.
How to Trade Underlying Assets?
There are two primary ways to trade underlying assets:
Direct Investment: You can buy and hold the underlying asset directly, such as purchasing stocks or bonds.
Through Derivatives: You can invest in derivatives that are based on the underlying asset, such as options or futures contracts.
Risks Associated with Underlying Assets
Investing in underlying assets involves several risks:
Market Risk: The value of the underlying asset can fluctuate due to market conditions, affecting the value of related derivatives.
Liquidity Risk: Some underlying assets may be difficult to buy or sell quickly, leading to liquidity risk.
Credit Risk: If the underlying asset is a debt instrument, there’s a risk that the issuer may default on their obligations.
Advantages of Investing in Underlying Assets
Diversification: Underlying assets offer investors the opportunity to diversify their portfolios across different asset classes.
Potential for Returns: Depending on the asset, there’s significant potential for returns, especially in equity and commodity markets.
Key Differences Between Underlying Assets and Derivatives
Direct Ownership vs. Contractual Rights: Investing in underlying assets gives you direct ownership, while derivatives provide contractual rights based on the asset’s performance.
Risk and Return Profiles: Underlying assets generally carry different risk and return profiles compared to derivatives, with the latter often involving higher leverage.
Real-World Example of Underlying Assets
Consider a crude oil futures contract. In this case, the underlying asset is crude oil. The value of the futures contract will fluctuate based on the price movements of crude oil in the market. A trader might buy a crude oil futures contract if they believe the price of oil will rise in the future. If the price does increase, they can sell the contract at a profit. Conversely, if the price drops, the value of the contract will decrease, leading to a potential loss.
Conclusion
Underlying assets are the foundation of derivative markets, influencing the value, risk, and potential returns of derivative contracts. Whether you’re investing in stocks, bonds, commodities, or currencies, understanding the role of underlying assets can help you make informed decisions and effectively manage your investments. Whether you use them for hedging, speculation, or risk management, it’s essential to be aware of the characteristics and risks associated with the underlying asset of any derivative you trade.
FAQs
What is the difference between an underlying asset and a derivative?
An underlying asset is the primary asset from which a derivative derives its value, while a derivative is a financial contract based on the performance of the underlying asset.
Can underlying assets lose all their value?
Yes, if the market conditions are unfavorable or if the asset issuer defaults, an underlying asset can lose significant value or even become worthless.
How do underlying assets affect the pricing of derivatives?
The price of derivatives is directly influenced by the price movements of the underlying asset. Changes in the asset’s value impact the derivative’s premium, strike price, and overall profitability.
Are underlying assets only used in financial markets?
While commonly associated with financial markets, underlying assets can also include real estate, commodities, and other tangible assets used in various industries.
What are some examples of underlying assets in the stock market?
Examples include individual company stocks, market indices like the NIFTY 50, BANKNIFTY and sector-specific indices like the NIFTY IT, NIFTY Pharma, NIFTY Metal.
