BAJAJ BROKING
March 01, 2025
7 mins read
A derivative is a popular financial instrument that does not have a value of its own but derives its value from an underlying asset. These underlying assets are what help define the price of a derivative. For traders who are looking to invest in derivatives, must understand what underlying assets are. This will help them evaluate risks and determine the value of derivatives before making investment decisions.
An underlying asset is the actual financial asset that decides the price of a derivative contract, which is a financial instrument that derives its value from an underlying asset. To help you understand this better, here is an example:
Let us suppose that a trader has an option contract for the stock of Company A. What this option contract does is give the trader the right, without the obligation, to buy or sell Company A stock. This is done at a specific price, known as the strike price, and it has to be exercised before the contract expires.
Here, the underlying asset is the stock of Company A, as its value determines the price of the option contract.
The concept of underlying assets is important for derivative contracts as they give derivatives their value, help determine the terms of the functioning of a financial contract and support the security that is a part of the derivative contract.
To help you understand the concept of underlying assets, here are a few examples.
Example of underlying assets in stock options:
When it comes to underlying assets in stock options, traders have to understand that the underlying asset of a derivative contract is the stock itself.
For example, let us suppose that a trader has an option to buy 100 shares of Company C at ₹100 per share. In this example, the underlying asset is Company C’s stock, as it is the price of the stock that determines the option’s value. The moment the stock price moves up or down, so does the option value. It is the value of the underlying asset that helps traders determine whether or not to exercise the option.
Traders, however, need to understand that not all underlying assets will be stocks. Some can have currencies or market indexes in their place.
There are many different types of underlying assets, each having its characteristics, advantages and risks that affect the movement of the derivatives. Here is a list of some of the most common ones:
Stocks: The stocks of a company are a symbol of part-ownership of a company, and this is what makes stocks one of the most popular underlying assets in the market.
Bonds: Bonds are debt securities that are issued by governments and corporations to raise funds for various reasons.
Currencies: Currency pairs like USD/INR or EUR/INR thrive in the forex market and can serve as the underlying assets for currency futures, options, etc.
Interest Rates: Another example of an underlying asset is financial contracts like interest rate swaps and futures. These protect traders through hedging or speculating on changes in interest rates.
Market Indices: Market indexes like the S&P BSE Sensex or Nifty 50 can serve as underlying assets for index futures and options. This helps traders place orders on overall market movements instead of individual stocks.
Real Estate: The concept of real estate as an underlying asset works for Real Estate Investment Trusts (REITs) or real estate futures. This provides traders with exposure to the property market without owning real estate directly.
It is the underlying asset in a derivative contract that gives the contract its value. They play a crucial role in determining how derivative contracts are priced and traded. Let us suppose a trader has an option contract on Stock ABC. With this contract, the trader gains the right, without the obligation, to buy or sell ABC at a predetermined price known as the strike price before the option expires. Since the stock of ABC decides the option’s value, it is the underlying asset in this instance.
With the underlying asset, derivative contracts provide a reference point to both trading parties. Since underlying assets play a major supportive role for the security involved, the contract makes it a key element in trading strategies.
Underlying assets play a crucial role in helping provide value to derivative contracts. Here are some of the main reasons that make underlying assets truly important:
Valuation: The main function of the underlying asset is to provide the derivative value. These help trailers determine which derivative contract to invest in, as the underlying assets help them determine the pricing for the derivative correctly.
Risk Management: One of the biggest functions of derivatives is to hedge against risks. This is where underlying assets can truly help.
Market Efficiency: When traders trade through derivatives with underlying assets in mind, they can make the market more liquid and efficient. This, as a result, will provide traders with more accurate price discovery and make the market more efficient.
Smart Investment Strategies: With the help of derivatives, investors get more exposure to assets without needing to own them. This becomes more cost-effective for the traders in question.
Derivative contracts, like options and futures, do not have a value of their own. These contracts derive their value from an underlying asset. This is precisely why they are named the way they are: derivatives, as they derive their value from the underlying asset. However, we should start at the beginning to help you understand what derivative contracts are.
Let us begin by first understanding an options contract. With the help of an option contract, the buyer gains the right without the obligation to buy or sell an underlying asset at a predetermined price on or before a specific date. In this, the option writer, also known as the option seller, has to either buy or sell the asset if the option buyer decides to exercise the option. If the buyer does not find that exercising the option would be profitable for them, then they can let the option expire worthless. In this case, their loss will only be limited to the premium they paid to the seller.
Futures work a bit differently when compared to options, as they define a commitment to trade for both the buyers and sellers. Under future contracts, the seller agrees to deliver the underlying asset at expiry, and the buyer agrees to purchase the same at a pre-determined price. Traders will rarely hold future contracts till expiry as they do not expect to make a lot of profit that way.
If you are a trader who is looking to invest in derivative contracts, you also need to understand how underlying assets and derivatives are connected. You see the value of derivative moves according to any changes that the price of the underlying asset may experience.
So, for example, a trader owns a call option on a stock, which is the underlying asset. Now, if the price of the stock goes up, the value of the option will also increase.
The relationship between the underlying asset and the derivative lets traders use the latter in two main ways: one is through hedging, which helps protect traders from potential losses by offsetting risks and the second is through speculation, which lets traders profit from price movements without even owning the asset.
To put it plainly, an underlying asset is essentially the foundation of derivatives. Since the derivatives don’t have a value of their own, they derive their value from their underlying asset. From stocks, bonds, or currencies, there are many types of underlying assets, and each comes with its unique characteristics. To understand how derivatives work, traders need to understand the concept of underlying assets better. This will end up opening numerous doors for traders where financial strategies and risk management are concerned.
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Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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An underlying asset is essentially the foundation of derivatives. Since the derivatives don’t have a value of their own, they derive their value from their underlying asset.
The value of a derivative moves according to any changes that the price of the underlying asset may experience. For example, if the price of the stock, which is the underlying asset in one case, goes up, the value of the option will also increase.
Yes, there are many types of underlying assets, and real estate is one of them. The concept of real estate as an underlying asset works for Real Estate Investment Trusts (REITs) or real estate futures. This provides traders with exposure to the property market without owning real estate directly.
Since underlying assets are of different types, the risks can range from market and credit risk to inflation risk as well. Market risk arises due to market volatility that ends up affecting the price of the underlying asset. If the price of the underlying asset falls drastically, the value of the derivative will also decrease suddenly. When using bonds or other debt securities as an underlying asset, credit risk can arise through default in payment of interest. With the rising cost of goods and services, inflation risk could also affect the underlying asset, which would further affect the derivative.
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