What is an Underlying Asset?

One key concept in the investment world is the concept of the underlying asset. Anyone involved in trading or investing needs to understand this crucial principle. The underlying asset is a term often mentioned in discussions regarding derivatives, options, futures and structured products.

If you’re just starting to explore investment opportunities and are learning the ropes of stock market terminology, the concept of the underlying asset can help you fundamentally understand how many markets operate, how risk is structured and why some assets can be more volatile than others. 

The underlying asset is a crucial element in understanding the core value of derivatives and other financial instruments, in this article we’ll cover its meaning and provide examples of underlying assets in various markets.

The Definition of the Underlying Asset

Simply put, an underlying asset is the actual asset upon which its derivative’s price is determined. A derivative is a term used for a financial contract whose value is ‘derived’ from the performance of something else - an ‘underlying asset’.

The underlying asset drives the value of the derivative as it is the ‘product’ from which value is derived. It could be anything of measurable financial value: a stock, commodity like oil or gold, currency pair, index (like the S&P 500), or even cryptocurrencies and interest rates. All these things can be traded on the market through their derivatives. When you trade gold, for example, you’re trading the derivative that relies on the performance of its underlying asset, in this case gold, which determines its value.

Say you’re trading a stock option contract that provides you with access to purchase shares of Apple Inc. at a predetermined price. In this case, Apple stock is the underlying asset, but the option itself is a separate contract that derives its value from the performance of that Apple stock.

The Most Common Types of Underlying Assets

Understanding the difference between an asset and its derivative can be complicated. An asset is not necessarily an underlying asset, for example in cases where it is traded directly. To clear things up, here are some common examples of where underlying assets tend to come up in the trading world.

1. Options - Stocks and Equities

Stock options are perhaps the most widespread example of a financial instrument that relies on an underlying asset. They give holders the right to buy or sell shares at a specific price before a certain date. Options are used by traders to ‘lock in’ a specific price by purchasing or selling an option to another trader. For example, a call option on Microsoft derives its price from Microsoft stock, making that its underlying asset. If the stock goes up, the value of the call option usually increases.

2. Futures and Options Contracts - Commodities

Common underlying assets in futures and options contracts can be commodities like gold, silver, oil and agricultural products. For example, oil futures contracts derive their value from the current and expected price of crude oil. These commodity-based contracts are often used for the purposes of hedging, especially by businesses that are highly exposed to changing prices of raw materials.

3. Index Derivatives

Derivatives based on indices, such as the S&P 500, NASDAQ or the Dow Jones Industrial Average, allow traders to speculate on the movement of the index without having to purchase its share right away. As with stocks we’re talking about derivatives such as options and futures.

4. Futures and Options contracts for Currency Pairs

Common underlying assets in the foreign exchange (forex) market are currency pairs used to derive value of corresponding options and futures contracts. These contracts are priced based on these pairs and are often used to hedge against currency fluctuations or to speculate on global macroeconomic events.

5. Interest Rate Derivatives

Derivatives like swaps or interest rate futures often use benchmarks such as the London Interbank Offered Rate (LIBOR) or the federal funds rate as their underlying asset. These financial instruments can be used by banks and institutional investors to adapt to changing interest rates and to manage exposure.

6. Cryptocurrency Futures and Options

As with other investment avenues, cryptocurrencies too are underlying assets in a new wave of financial products. Crypto options and futures let investors gain exposure to the crypto market and its price movements without having to own the coin itself.

Examples of How Underlying Assets Work in Financial Products

Say you purchase a call option for 100 shares of Microsoft at $400 per share and the price at the time of purchase stands at $380. If the price of the stock rises to $420, the call option becomes “in the money” because it allows you to buy it for the predetermined price of $400 and instantly sell it at $420 to the market, pocketing the difference (after covering the premium you paid for the option). In this instance, the increase of the underlying asset’s price (the Microsoft stock) is what increased the value of your derivative

This principle works in the same manner for other derivative products. It does not matter if you’re purchasing futures contracts on wheat or an index option on the NASDAQ-100 the principles remain the same, the price of the financial instrument is directly influenced by the price movements of its underlying asset.

Using Financial Instruments With Underlying Assets

There are plenty of reasons to choose financial instruments such as futures and options in which underlying assets play a role. Instead of investing directly into an asset you may choose to go through derivatives for a number of reasons, we’ve highlighted the most common use cases here.

Risk Assessment

Purchasing derivatives can shield you from large “dips” of a potentially unstable asset. By securing options you can decide to avoid buying the underlying asset if the price is less desirable than expected. You’ll lose the option and thus the premium paid to secure it but it can turn out to be a much smaller loss than if you were to purchase the asset directly.

Hedging Strategies

As an example, if you’re running a business that’s highly exposed to fuel costs, you could use futures contracts with underlying assets based on oil prices as a hedging strategy to reduce costs or, as another example, if you export to a specific region you could use currency futures to hedge against unfavorable exchange rates.

Safer Speculation Opportunities

Derivatives help investors stay in relevant markets without exposing themselves to large risks by purchasing assets directly. Options and futures do come with costly premiums sometimes however the control provided by options can be a much needed safety buffer in volatile markets.

Bottom Line

The underlying asset is at the core of its derivative, providing the value for the derivative. In short, the underlying asset is the asset itself, like a particular stock, in the context of a financial derivative that derives its value from the underlying asset.

The underlying value dictates how an option, future or swap gains or loses its value. Its behavior on the market directly affects the instruments tied to it.

Beginners should focus on the underlying asset and how the asset itself is performing in the market rather than the price movements of the derivative. Knowing the context behind currency pairs, cryptocurrencies, price of raw materials like oil or precious metals can help you make informed decisions when investing in related derivatives.

If you’re a beginner investor, consider checking out our overview of the best online stock brokers for beginners which can help you choose the right broker for you if you’re looking to start trading derivatives or if you’re interested in investing in general.