Types of Underlying Assets in Derivatives & Its Characteristics

The finance market is a challenging yet spirited sector where derivates play a key role. These are typically associated with underlying assets. But what is the derivative underlying asset? As an increasing number of individuals are diving into finance and stocks, it is necessary to understand these terms and what they entail.   

Derivative underlying asset: Discerning the basics

The price of the underlying asset affects the derivative directly or indirectly. Trading derivatives usually involves predicting the future price fluctuations of the underlying asset.

Underlying assets

In easy terminology, an underlying asset is the foundation based on which derivatives are built. An underlying asset is referred to as an actual financial security. A financial derivative depends on it. Consider an underlying asset as the base on which the intricate structure of financial tools lay. However, several factors make an asset an underlying part of a contract for derivatives. It is this asset’s performance that defines the derivative’s worth. 

A quick illustration

To better understand what is underlying asset in derivatives, let’s consider and illustration.  For the purpose of the example, the company name and prices mentioned are assumed. The firm whose shares and futures (the derivative) are listed and traded on the market is ABC. This is the underlying asset of the derivative.

ABC shares are now the basis for ABC futures. In other words, the underlying assets are ABC shares. “Basis” is the difference between the price of the underlying asset and the futures. In this case, it can be assumed as ₹2,600 for ABC shares and ₹2,605 for ABC futures.

Basis is the difference between the underlying security’s futures pricing and its spot price. It is possible for the basis, or the difference, between the price of the underlying security and the related derivative to be zero, positive, or negative.

1. ABC’s quarterly results showed a 20% increase in revenue, leading to a rally in ABC shares and futures to ₹2,650 and ₹2,655 respectively.
2. ABC’s quarterly results showed a 20% decrease in revenue, leading to a decline in share price and futures trading at ₹2,615 compared to the pre-announcement level.

Here it is seen that ABC futures and ABC shares’ prices mirrored each other in terms of direction, momentum, and proportion due to their shared underlying price. 

How many forms of underlying assets are there?

There are different types of underlying assets in derivatives. These are:

1. Stocks 

These are equity-based assets representing company ownership. The derivatives’ value alters with the performance of the company. Stocks are one of the most commonly used underlying assets in the capital market. Stocks provide greater alternatives for hedging and speculation for derivative investors since they are exchanged so often on financial markets. Exchanges have established standards for equities that can be utilised as F&O trading’s underlying assets.

2. Currency

A common way of exchanging goods and services is money. Payment in this type is well recognized and used inside its borders. The Government mostly uses it. Currency derivatives, such as currency swaps, currency futures, and currency options, employ currency as the underlying asset.

Foreign exchange derivatives have their base in currency pairings. These have increased susceptibility to world events related to the economy and geopolitics. Foreign exchange is an active type of asset. 

3. Stock market indices

Stock market index is the statistical measure of the market’s performance that takes into account its ups and downs is called. It conveys the market’s general attitude. Indexes of the stock market may be the underlying asset of a derivative contract. The derivative products using market indices as the underlying asset are index futures and index options.

4. Commodity 

Oils, gold, and agricultural goods form the backbone of this category of derivatives. Changes directly influence the derivative worth in the commodities market. 

5. Interest Rate 

Interest rates have a major impact on finance. Derivatives that are interest rate-sensitive react to variations in borrowing costs. This makes them an essential part of financial strategy. 

6. Cryptocurrency 

With digitalization, cryptocurrencies like bitcoins have entered the derivative landscape. Out of all the types of underlying assets and derivatives, this is the most unpredictable kind.

7. ETFS of Exchange-Traded Funds 

These form a group of assets that are traded on stock exchanges. These follow an underlying index. Derivatives based on ETFs are called ETF futures and options. These are not yet available in India.

Defining the characteristics of derivative underlying assets

1. Uncertainty 

The uncertain aspect of an underlying asset is evaluated based on its price fluctuations. Although this feature enhances risk, it also paves the way for bigger gains.

2. Liquidity

Liquidity or accessibility is the comfort with which an asset can be purchased and sold. This happens without significant price change. To ensure fair prices and seamless trading, high liquidity is preferred. 

3. Maturity 

Maturity is the period of the contract before expiry. The maturity period has significant implications for the risk and profit profile of the derivative. 

4. Dividends

Underlying assets that are equity-based have an important characteristic called dividend. It is important to understand how dividends can affect derivative value. It is basically the disbursement of company earnings to shareholders. The board of directors decides on the dividend and is often viewed as a liability by the company.

Derivatives vs. Underlying assets

Although often used synonymously, there is a difference between derivative and underlying asset. To tread in finances, it is crucial to understand the fundamental difference between the two.

Underlying Asset

• It is the main financial element that serves as the foundation for the derivative contract, such as stocks, bonds, indices, currencies, or commodities.
• In essence, it’s what gives the derivative its value.
• One stock or commodity would be an example of an underlying asset.

Derivative:

• A derivative contract is an arrangement to purchase or sell the underlying asset on a certain date for a fixed price.
• It gets its worth from the asset that underlies it.
• A futures trader could purchase or sell a contract that calls for the delivery of an underlying stock on a specific future date.

Conclusion 

The derivatives market is a fascinating area formed of underlying assets. The different types of assets, with their distinct characteristics, bring specific value to the derivative. To maneuver the landscape of derivative underlying asset, knowledge and in-depth understanding are the key to success. A solid grasp of these fundamental concepts will make handling the ups and downs smooth and effective.

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