Underlying Asset: Meaning, Types and Working
The derivative segment of India’s stock markets is popular among traders. This is because of its several benefits like price discovery, price stabilisation, portfolio diversification, hedging, etc. Derivatives do not have a value of their own; they derive their value from their underlying asset.
Underlying assets are financial assets that influence the price of derivative contracts. Let’s delve into their different aspects!
What Are Underlying Assets?
These are financial assets that determine the price of derivative contracts. In simpler words, we can say that these assets grant certain value to derivatives.underlying assets can be stocks, commodities, currencies, benchmark indices, etc.
You can purchase a derivative contract whose underlying asset is, let’s say, stock of Company ABC. As per the contract, you can buy or sell the stock of ABC at the agreed strike price on or before the expiration date. An underlying asset’s primary purpose is to support derivative contracts agreed upon by buyers and sellers.
Now that you are aware of the meaning of underlying assets, let’s shift our discussion to other aspects of the same.
What Are the Types of Underlying Assets?
The various types of underlying assets have been discussed below:
Stocks or shares of a company get influenced by a host of factors like overall market risks, fundamentals of the company, general economic situation, etc. The market forces of demand and supply are the primary determinants of the prices of such underlying assets.
Another instrument used as an underlying asset for derivatives is currency. Some currencies that act as underlying assets are the US Dollar, Great Britain Pound, Euro, etc. These financial instruments are subject to several risks like interest rate risk, sovereign debt risk, etc.
- Market indices
This includes benchmark market indices like Nifty 50, Sensex, Bank Nifty, etc. Again, these underlying assets are also subject to inherent market volatility. Prices of these instruments are primarily dependent on market forces of demand and supply.
These are fixed-income instruments that are used to raise money by both public and private companies. Usually, the risk involved in these securities is quite low. Some examples of these instruments include government bonds, treasury bills, corporate bonds, infrastructure bonds, etc.
These are economical goods like food products, metals, petroleum, coal, natural gas, etc., which can be traded in the commodity market. Prices of commodities are predominantly dependent on demand and supply and global macroeconomic conditions.
Example of an Underlying Asset
Let’s discuss an example that will help you gain clarity on the functioning of underlying assets.
Suppose the shares of Company XYZ are available for trading in stock markets. The prevailing market price of the stock stands at ₹1400, and a call option contract of this stock with an expiration timeline of one month has a strike price of ₹1420.
Now, let’s say that Company XYZ has announced its quarterly results. The quarterly profits have increased by a whopping 50%, and this has led to an increase in the share price to ₹1500. Consequently, the profit generated from the call options contract written on it will also increase proportionally. In this case, your profit will be ₹80/share.
In contrast, it can also happen that the company announces a loss in its quarterly results. Let’s say that the share price has fallen to ₹1300 from the pre-announcement level. The price of call options contracts will also fall down massively from earlier levels as a consequence.
Therefore, we see that the price of the concerned underlying asset greatly influences the value of concerned derivative contracts.
An underlying asset is a financial asset that helps in determining the value of a derivative contract. There are various factors, like the corresponding company’s fundamentals, general macroeconomic situation, etc., that influence the value of an underlying asset.
If you are planning to invest or trade in India’s derivatives segment, it is important to conduct a thorough analysis of underlying assets before taking any position.
Frequently Asked Questions
What are the types of derivative contracts?
The two types of derivative contracts are futures and options. The former allows you to buy or sell the underlying assets of the contract on or before the expiration date. The latter gives you the right, but not any obligation, to buy or sell the assets.
What are the advantages of derivatives?
Some of the major advantages of derivatives are that they are highly liquid and marketable. The return potential of these contracts is quite high. Furthermore, You can hedge your portfolio using financial derivatives.
What are the limitations of underlying assets?
You can invest in derivatives of certain underlying assets for speculative purposes, which is risky as they may incur losses. Apart from this, some derivatives come with over-the-counter settlements and therefore possess counterparty risk.
What are market indices?
A market index tracks the performance of a certain group of securities to reflect the changes occurring in a particular segment of the financial markets. They are designed to let you compare a specific group of stocks based on their value.