Underlying

What Is Underlying?

In finance, an underlying refers to the original asset or financial instrument upon which the value of a derivative contract is based. It is the fundamental security, commodity, currency, or index that a derivative contract (such as a futures contract, options contract, or swap) refers to. The price movements of the underlying directly influence the price of the derivative. This concept is central to the derivatives market, a sophisticated segment of the financial system where contracts are traded based on the value of other assets. Without an underlying, a derivative would have no intrinsic value or reference point.

History and Origin

The concept of an underlying asset in relation to financial contracts dates back centuries, even before the formalization of modern derivatives markets. Early forms of derivative agreements, such as forward contracts on agricultural commodities, existed to manage price risk associated with future harvests. Farmers and merchants would agree on a price for a future delivery of grain, with the grain itself serving as the underlying asset.

The formalization and widespread adoption of exchange-traded derivatives, and thus the prominence of the underlying, gained significant momentum in the 20th century. A pivotal moment was the establishment of the Chicago Board Options Exchange (CBOE) in 1973, which introduced standardized, exchange-traded options contracts on stocks. This innovation made options trading more accessible and transparent by standardizing contract terms and establishing a central clearinghouse. Before this, options were traded over-the-counter with varying terms and less transparency.¹¹, ¹²

Key Takeaways

• An underlying is the asset or financial instrument from which a derivative contract derives its value.
• Common underlyings include stocks, bonds, commodities, currencies, and interest rates.
• The price fluctuations of the underlying directly determine the value and potential profit/loss of the associated derivative.
• Understanding the characteristics and volatility of an underlying is crucial for participants in the derivatives market.
• Underlying assets are essential for purposes such as hedging risk and speculation.

Interpreting the Underlying

Interpreting the underlying involves assessing its fundamental characteristics and how its potential future price movements could impact a derivative. For example, if the underlying asset is a company's stock, investors analyze the company's financial health, industry trends, and overall market sentiment to predict the stock's future market price. This analysis is critical because the value of derivative products, such as options or futures, is inextricably linked to the performance of their underlying. A rise in the underlying stock price might increase the value of a call option, while a fall could benefit a put option. Similarly, for commodity derivatives, understanding supply and demand dynamics, geopolitical events, and weather patterns that affect the underlying commodity is essential.

Hypothetical Example

Consider an investor, Alex, who believes that the stock price of "TechInnovate Inc." (TI) will increase in the coming months. The TI stock is trading at $100 per share. This stock is the underlying asset.

Instead of buying 100 shares of TI directly for $10,000, Alex decides to purchase a call option contract on TI stock. Each options contract typically controls 100 shares of the underlying. Alex buys one call option with a strike price of $105 and an expiration date three months away, paying a premium of $3 per share, or $300 for the contract.

If, after two months, the TI stock (the underlying) rises to $115 per share, Alex's call option is now "in the money" because the underlying's price is above the $105 strike price. Alex can choose to exercise the option and buy 100 shares at $105 each, then immediately sell them in the market at $115, realizing a profit. Alternatively, Alex can sell the call option itself, which has gained value due to the appreciation of its underlying asset. If the underlying had fallen below $105, the option might expire worthless, illustrating the direct relationship between the derivative and its underlying.

Practical Applications

The concept of an underlying is fundamental across various financial applications, primarily within the derivatives market. Financial institutions and corporations use derivatives based on specific underlyings to hedge against adverse price movements in their core assets or liabilities. For instance, an airline might use futures contracts on crude oil to lock in fuel costs, with crude oil being the underlying. Similarly, companies with international operations may use currency swaps to manage foreign exchange risk, where different currencies serve as the underlying.

Underlying assets also play a crucial role in speculation, allowing traders to bet on the future price direction of an asset with potentially less capital outlay than buying the underlying directly, often involving leverage. Regulatory bodies, such as the U.S. Commodity Futures Trading Commission (CFTC), oversee these markets to ensure integrity and prevent manipulation, highlighting the systemic importance of the trading infrastructure that supports underlying assets and their derivatives.⁸, ⁹, ¹⁰ This includes the oversight of financial market utilities (FMUs) that provide critical infrastructure for transferring, clearing, and settling transactions involving underlying assets and derivatives.³, ⁴, ⁵, ⁶, ⁷

Limitations and Criticisms

While essential for derivative instruments, reliance on an underlying asset also introduces certain limitations and criticisms. The primary concern is the amplification of risk, particularly through leverage. A small movement in the price of the underlying can lead to significant gains or losses for derivative holders, often exceeding the initial investment. This characteristic can contribute to systemic risk if large positions in derivatives tied to specific underlyings face sharp, unexpected movements, potentially impacting market stability.

Furthermore, the complexity of some derivative instruments, especially those with multiple or highly abstract underlyings (like certain indices or baskets of assets), can make it challenging for investors to fully understand the risks involved. This opacity can lead to mispricing or unexpected exposures. Financial crises have sometimes highlighted instances where complex derivatives, whose underlying risks were not fully understood, contributed to broader market instability. The Federal Reserve Bank of San Francisco has published on the complexities and potential risks of derivatives.¹, ²

Underlying vs. Derivative

The terms "underlying" and "derivative" are closely related but refer to distinct concepts. The underlying is the actual asset, index, or rate that a financial contract is based upon. It exists independently and has its own inherent value. Examples include a share of stock, a barrel of crude oil, a specific bond, or a foreign currency.

A derivative, on the other hand, is a financial contract whose value is derived from the performance of that underlying asset. It is not the asset itself, but rather a contract or agreement about the asset. For example, a call option on a share of Apple stock is a derivative; the Apple stock itself is the underlying. The option's value changes as the Apple stock price changes, but owning the option does not mean owning the stock until the option is exercised. Derivatives are tools to manage or assume risk related to the underlying without necessarily owning it.

FAQs

What types of assets can be an underlying?

Almost any measurable asset or financial instrument can serve as an underlying. Common examples include stocks, bonds, commodities (like oil, gold, agricultural products), currencies, interest rates, market indices (like the S&P 500), and even other derivatives.

Why is the underlying important for derivatives?

The underlying is critical because it gives the derivative its value. Without an underlying, a derivative contract would be meaningless, as there would be no reference point for its price or performance. All pricing models and risk assessments for derivatives depend heavily on the characteristics and expected behavior of their underlying.

Can an underlying asset itself be a derivative?

Yes, in some complex financial structures, a derivative can serve as the underlying for another, more complex derivative. For example, an option on a futures contract would have the futures contract as its underlying. This layering can increase complexity and leverage.

How does the volatility of the underlying affect derivatives?

The volatility of the underlying asset significantly impacts the pricing of many derivatives, especially options. Higher expected volatility in the underlying generally leads to higher premiums for options, as there is a greater chance of significant price movement, increasing the potential for the option to expire in the money.