Underlying refers to the unit on which a derivative financial instrument (a contract) is based on the market. For example, in the foreign exchange market, the underlying asset will be currency, in the stock market — securities, etc. In other words, it is the name of the asset with which the purchase, sale, delivery is performed under the contract. The value of the asset is considered to be the main variable used for calculation when executing transactions.
If the price of the underlying changes, the value of the derivative asset linked to it also increases or decreases.
Both equity and financial derivatives are based on the underlying. The value of the derivatives contracts is derived from the value of other assets, such as commodities, currencies, interest rates and so on. So, the interest rate can act as the underlying asset in derivative transactions. If the interest rate rises, a price movement of the derivative can be seen as well.
The asset referred to in the futures contract is also called the underlying asset. The underlying asset of the futures can be a commodity, for example, zinc, coal, corn, aluminum. The uncertainties in commodity markets can have a great impact on commodity futures.
Convertible bonds, corporate bonds that provide an investor with the right to convert bonds into shares of the issuer on pre-determined conditions, are also conditional on the price of the underlying asset. Since the price of a convertible bond is influenced by the price of a related share, the shares are known as the underlying asset to the convertible bonds.
“Underlying” is the common term used when discussing derivatives, which are frequently linked to another asset. Contractually regulated option transactions whose evaluation is derived from the development of the underlying asset is one of the most widespread derivatives transactions. Options transactions can be very lucrative for a trader.
Nevertheless, the underlying assets in derivative transactions can also be benchmarks, bonds, stocks, interest rates and stock market indices. Derivative is a security whose value depends on the price of the underlying asset, meaning that the value of the derivative is determined by fluctuations in that asset. It should be mentioned that another derivative can also serve as the underlying.
Advantages and disadvantages of Underlying
When a trader makes a transaction with derivatives, they expect that the price will increase significantly over a certain period of time. However, it is important to consider such metrics as the underlying asset or index. Each type of an asset has its own level of risk and income, which influences the derivative contracts linked to it. An investor can face market risk and lose money in shares, bonds, and derivatives.
Nevertheless, underlying assets are generally less risky in terms of volatility than the derivatives. As stock prices are influenced by supply and demand, the stock market fluctuation can occur but there’s practically no chance you'll lose all your money invested in shares.
Speculative trading in derivatives can have a negative effect on underlying assets and this is one of the cons. For instance, in 2007, rising home prices were seen in the housing market and the reason for that was speculative trading in mortgage-backed securities and the creation of extremely complex derivatives contracts. When the dynamic bubble-collapse process began in 2008, the values of the underlying assets slashed.
There are two types of option derivatives: put option and call option. A call option provides its holder with the right to purchase the underlying asset at the price that was fixed by the contract between the two parties. If a small company's stock is trading for $6 per share and the price that the underlying asset referenced in a contract is $2, there’s an upward trend in the price of a stock, it means that the call is worth $4. Here the asset is the stock valued at $6 and the derivative refers to the call valued at $4.
A put option gives the buyer an opportunity to sell an asset at a fixed price on or before a certain day. If a small company's stock is trading for $6 per share and the price that the underlying asset referenced in a contract is $9, there’s a downward trend in the price of a stock, it means that the put is trading $3 in the money and is worth $3. Here the asset is the stock valued at $6 and the derivative refers to the put option valued at $3.This is a clear example of the dependance of the call and the put derivative contracts on the underlying asset.