Definition
In finance, an underlying asset refers to the financial instrument, such as stocks, bonds, commodities, currencies, indexes, or the like, which is the subject of a derivative contract like options or futures. These derivative contracts derive their values from the fluctuations in the price of the underlying assets. The holders of these derivatives may choose to buy or sell the underlying asset on a future date at a price agreed upon in the present.
Phonetic
The phonetics of the keyword “Underlying Asset” is: ʌn·dər·lai·iŋ æs·ɛt
Key Takeaways
- An Underlying Asset is a financial term describing the actual asset on which the value of specific securities, like derivatives or options, are based. It represents the physical or financial asset that investors can purchase or sell when exercising their options.
- The value and performance of the Underlying Asset directly influence the pricing and profitability of the derivative securities. Hence, investors frequently monitor the status of the underlying asset to make informed decisions.
- Underlying Assets could include a range of financial products like stocks, commodities, market indexes, bonds, currencies, or interest rates. It is because of such wide-ranging underlying assets that the derivatives market provides a comprehensive spectrum of trading and investment opportunities.
Importance
The term “Underlying Asset” is important in the world of business/finance because it refers to the financial asset upon which derivative securities like futures, options and swaps are based. These derivative contracts derive their value from these underlying assets. Therefore, the condition and projected performance of the underlying asset significantly impact the value of the derivative securities. Understanding the underlying assets helps investors to manage risk and make informed decisions as it provides vital information about the potential profitability, volatility and liquidity of the investment. Therefore, it plays a crucial role in evaluating, comparing and selecting investment options.
Explanation
The underlying asset serves as a fundamental element within the financial domain as it instigates the value for a broad array of derivatives. Essentially, it is responsible for providing value to derivatives including futures contracts, options, forwards, or other financial contracts. The purpose has much to do with risk management, as it helps to either shift, drift, or consolidate the risk associated with the market fluctuations in the price of the underlying asset. It is, thus, an established method to guarantee more stable business operations for corporations, traders, and investors, as these derivatives allow them to hedge against potential losses or speculate on future movements of the underlying asset. Underlying assets can include things like stocks, commodities, market indices, bonds, currencies and even other derivatives. They are effectively used to derive benefits from desired price movements. For instance, an investor might buy a derivative contract based on an underlying asset if they predict that its price will rise, allowing them to benefit from the increase without having to buy the asset itself. It also offers the leverage to control the asset for a fraction of its original price thereby increasing the profitability of the investment. Overall, the use of underlying assets is significant in financial markets to maintain a robust and flexible trading environment.
Examples
1. Stocks: In options trading, an investor may have a contract that grants them the right to buy or sell a specific stock at a predetermined price. In this case, the underlying asset is the stock itself. 2. Commodities: In a futures contract for oil, the underlying asset is the actual commodity of crude oil. The buyer of the oil future has an obligation to buy the specified amount of oil at the delivery date, unless the holder’s position is closed prior to expiration. 3. Property: In a mortgage-backed security, the underlying assets are the individual mortgages that back the security. The income from these mortgages is used to pay the returns for holders of the mortgage-backed security.
Frequently Asked Questions(FAQ)
What is an Underlying Asset?
How does an Underlying Asset relate to derivatives?
Can an Underlying Asset be a physical commodity?
What happens to the derivative if the value of the Underlying Asset changes?
Are there risks associated with Underlying Assets?
What happens if the entity issuing the Underlying Asset goes bankrupt?
Can multiple different derivatives be based on the same Underlying Asset?
How do investors make money from Underlying Assets?
How can I invest in Underlying Assets?
Related Finance Terms
- Derivative Instruments
- Securities
- Option Contracts
- Futures Contract
- Commodity Pricing
Sources for More Information
