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Underlying Asset



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

  1. 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.
  2. 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.
  3. 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?
An Underlying Asset is a financial term used to describe the actual financial instrument or commodity upon which a financial derivative or contract is based. It can include stocks, bonds, commodities, currencies, interest rates, or market indexes.
How does an Underlying Asset relate to derivatives?
A derivative’s value is based on the price of the Underlying Asset. The performance of this asset decides the price and trading of the derivative. Examples of derivatives include options, futures, and swaps.
Can an Underlying Asset be a physical commodity?
Yes, an Underlying Asset can be a physical commodity such as gold, oil, or wheat. It could also be a financial instrument like a stock, bond, or currency.
What happens to the derivative if the value of the Underlying Asset changes?
When the value of the Underlying Asset changes, it impacts the value of the derivative. For instance, if you have a call option (a type of derivative) on a stock (the Underlying Asset), and the price of that stock goes up, the value of your call option would also increase. Thus, the price of the derivative is directly related to the price of the Underlying Asset.
Are there risks associated with Underlying Assets?
Yes, as with any financial instrument, there are risks. These include market risk related to price fluctuations of the Underlying Asset, the risk of the issuer defaulting, and liquidity risk. The derivatives based on these assets also come with their unique risks.
What happens if the entity issuing the Underlying Asset goes bankrupt?
If the issuing entity goes bankrupt, it could render the Underlying Asset worthless. This would also impact any derivatives that are linked to that asset, likely causing them to also become worthless.
Can multiple different derivatives be based on the same Underlying Asset?
Yes, multiple different financial derivatives can be based on the same Underlying Asset. For instance, both call options and put options could be created using the same stock as the Underlying Asset.
How do investors make money from Underlying Assets?
Investors can make money from Underlying Assets either by trading the assets themselves or through financial derivatives based on those assets. In both cases, profits typically come from correctly predicting changes in the price of the Underlying Asset.
How can I invest in Underlying Assets?
By purchasing the asset directly or investing in financial products such as mutual funds, index funds or exchange-traded funds (ETFs) that hold the asset. Another method is by buying derivatives that use the asset as an Underlying Asset. But it’s important to have a deep understanding of the asset and the associated risks before investing.

Related Finance Terms

  • Derivative Instruments
  • Securities
  • Option Contracts
  • Futures Contract
  • Commodity Pricing

Sources for More Information


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