The asset on which financial instruments, such as derivatives, are based is referred to as the underlying asset, and its value is directly or indirectly linked to the contracts of the derivatives. The derivatives produced from them are always traded on the futures markets, whereas they are always exchanged on the cash markets. (A Derivative is a financial instrument derived from another financial asset.)
- The tangible financial belongings or security based on financial derivatives are the underlying asset in the investment realm.
- Some underlying assets are Interest rates, bonds, stocks, commodities, market indices, and currencies.
- Different underlying asset classes and financial derivatives are exposed to various types of investment risk.
Types of Underlying Assets:
Stock options are among the most well-known and frequently traded financial derivative products. Derivatives like stock options have a value dependent on the underlying asset, the real stock. For instance, a call option on a stock gives the buyer the ability to buy the stock at a specific price (the option’s strike price) until the option expires.
Debt Securities or Bonds
A bond is a financial instrument that provides the holder with set interest payments. Bonds are issued by businesses and government entities to raise money for funding commercial and government projects. Such instruments’ owners are referred to as creditors of debt.
The underlying assets influencing the development of several financial derivatives include bonds, stocks, interest rates, commodities including gold, and currencies. Forward contracts, and collateralized debt obligations (CDOs), credit default swaps (CDS) are some of the most well-known financial derivatives, along with options (CDOs).
Underlying assets examples
Here are a few examples to help you understand:
- Consider an underlying asset with a downward risk, such as stocks A bought for $100.
- The holder holds 2 shares of stock A. The holder has the chance to purchase a put option on Stock A with a $100 strike price that is now trading at $10.
- A put option, a derivative contract, offers the right to sell the underlying asset at a defined strike price before the expiration date.
- The put option grants the right to sell, but there is no duty.
- The stock A from which the put option was developed and formed serves as the underlying asset in this situation.
Gold is a commodity that is a highly well-liked instrument that can be used for investing as well as security purposes. Gold may be used to stop growing inflation rates, stopping any possible decline in the value of US dollars.
- The dollar carries the distinction of being a widely recognized form of money.
- Gold is an underlying asset that never loses its value.
- Gold can be a backup investment when the dollar value declines due to growing inflation. (See the definition & example of hyperinflation here)
- Mechanism to prevent value loss, control inflation, and lessen the possible effects of a currency collapse.
Financial derivatives are often used in investing as risk management tools. For instance, a stockholder who owns many instruments of a certain commodity may use derivative options on the stock to protect his investment in the underlying asset.