Menu
sharewise sharewise
Log in
Sign up
Log in
Sign up
Microsoft strongly encourages users to switch to a different browser than Internet Explorer as it no longer meets modern web and security standards. Therefore we cannot guarantee that our site fully works in Internet Explorer. You can use Chrome or Firefox instead.

Dictionary

Understanding the Financial Term: Underlying Asset

Before delving into a financial market discussion, it is essential to understand the term "underlying asset." From stocks to bonds and other financial instruments, the underlying asset holds significant importance in the financial world. So, what exactly is it, and why should you care? Read on to find out!

What is an Underlying Asset?

An underlying asset, simply put, is the financial instrument that forms the basis of a derivative contract. A derivative is a financial instrument whose value depends on, or is derived from, the value of another asset or group of assets. These other assets are known as the underlying assets. Common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indexes. Derivatives play an essential role in hedging financial risks and speculating on market movements.

Key Features of Underlying Assets

  1. Variety: Underlying assets can be from various classes, such as stocks, bonds, commodities, and currencies. They can also be tangible or intangible.

  2. Influence: The value of a derivative is primarily determined by its underlying asset. A change in the value of the underlying directly impacts the derivative's value.

  3. Liquidity: The liquidity of an underlying asset significantly affects the trading of its derivatives. A highly liquid underlying asset leads to a more liquid market for its derivatives, making it easier for traders and investors to enter and exit their positions.

  4. Price: The price of the underlying asset is a significant factor in determining the value of its derivatives. For example, the higher the stock price, the higher the value of a stock option that allows the holder to buy that stock at a predetermined price.

Examples of Underlying Assets

Here are a few examples of how underlying assets work with various financial instruments:

  1. Stocks: In the case of a stock option, the underlying asset would be the specific stock on which the option is written. For example, if an investor bought an Apple Inc. call option, the underlying asset would be Apple's stock.

  2. Bonds: For a bond futures contract, the underlying asset would be a specific bond or a basket of bonds. For instance, a US Treasury bond future would have a specified US Treasury bond as its underlying asset.

  3. Commodities: In commodity derivatives, some common underlying assets include crude oil, gold, and agricultural products like soybeans and corn. For example, an oil futures contract would have a certain quantity of crude oil as its underlying asset.

  4. Currencies: In a currency option, the underlying asset would be a specific currency pair, such as the EUR/USD or GBP/JPY. The option would allow the holder to exchange one currency for another at a predetermined exchange rate.

  5. Indexes: In the case of index options or futures, the underlying asset would be a financial market index, like the S&P 500, Dow Jones Industrial Average, or the NASDAQ Composite.

The Importance of Underlying Assets

Understanding the concept of underlying assets has several implications for traders, investors, and the broader financial market. Here's why underlying assets matter:

  1. Risk Management: Derivatives allow investors to manage their financial risks more effectively. By using a financial instrument that derives its value from an underlying asset, investors can hedge their exposure to changes in the underlying asset's value.

  2. Leverage: Investing in derivatives provides investors with leverage, allowing them to access assets or exposure that may be too costly or challenging to invest in directly. For example, an investor could use an option contract to leverage a large position in a stock without having to invest as much capital upfront.

  3. Diversification: The concept of underlying assets facilitates diversification in an investment portfolio. Investors can access various underlying assets through derivatives, which often have lower barriers to entry than direct investment.

  4. Price Discovery: The existence of derivatives on underlying assets helps facilitate better price discovery. Trading in derivative markets often provides valuable information about the underlying asset's future prospects, leading to more efficient pricing and a more transparent market.

  5. Economic Activity: Derivatives based on underlying assets help drive economic activity by enabling businesses to hedge their exposure to commodity price movements, exchange rate fluctuations, and interest rate shifts. This helps create stability and growth in the broader economy.

To sum up, the term "underlying asset" carries vital significance in the world of finance. Not only do they form the basis for derivative contracts, but they also play a considerable role in managing risk and enabling more efficient financial markets. By understanding the concept of underlying assets, investors and traders can make better-informed decisions and navigate the complexities of the financial world with greater ease.

Feedback