A financial "underlying" refers to the core asset, index, or benchmark from which the value of a derivative contract is derived. In the broader context of the derivatives market, the underlying is the foundational element that gives a derivative its intrinsic relevance and whose price movements directly influence the derivative's worth.46, 47
History and Origin
The concept of financial contracts whose value depends on an underlying asset is not new. Early forms of derivatives can be traced back to ancient civilizations, with examples found in Mesopotamia around 2000 BC, where agreements for future delivery of goods or crops were common.42, 43, 44, 45 For instance, the Code of Hammurabi included provisions that could cancel interest on land loans if crops failed due to natural events, acting as an early form of a contingent clause.41
The formalization of such contracts progressed over centuries. In the late 17th century, Japan saw the development of a futures market in rice at Dojima to help protect producers from price volatility.39, 40 The 19th century marked a significant period with the establishment of organized exchanges for standardized commodity contracts in the United States, notably the Chicago Board of Trade (CBOT) in 1848, which listed the first exchange-traded futures contracts in 1865.37, 38 The proliferation of new valuation techniques in the 1970s, coupled with technological advancements, spurred the rapid development and widespread adoption of the modern derivatives market, expanding the range of underlying assets beyond traditional commodities to include various financial instruments.33, 34, 35, 36
Key Takeaways
- An underlying is the primary asset or benchmark from which a derivative's value is derived.31, 32
- Common examples of underlying assets include stocks, bonds, commodityies, currencyies, and interest rates.28, 29, 30
- The price movements and characteristics of the underlying directly influence the derivative's price and risk profile.26, 27
- Understanding the underlying is crucial for investors and traders to assess the risk and value of derivatives.25
- Underlying assets are typically traded in cash or "spot" markets, while derivatives are traded on specialized exchanges or over-the-counter.24
Interpreting the Underlying
Understanding the underlying asset is paramount when dealing with derivative instruments because the derivative's value is fundamentally dependent on its performance. For example, the value of an option or a futures contract directly fluctuates with the price of its underlying. Traders and investors must analyze the underlying asset's market conditions, volatility, and potential future price movements to make informed decisions about the associated derivative.23
The characteristics of different classes of underlying assets also dictate the nature of the risks involved. For instance, stocks are subject to market and economic risks, while bonds are exposed to default and interest rate risks. Currencies, on the other hand, can be influenced by interest rate and political risks.22 A comprehensive understanding of these underlying dynamics helps in evaluating the potential profitability and risks of derivative positions.
Hypothetical Example
Consider an investor interested in Company ABC's common stock, which is currently trading at $100 per share. The investor believes the stock price will increase in the near future but wants to limit potential downside risk. Instead of buying the shares directly, the investor purchases a call option on Company ABC with a strike price of $105, expiring in three months, for a premium of $3 per share.
In this scenario, Company ABC's stock is the underlying asset. The value of the call option is entirely derived from the price movements of this underlying stock. If, at expiration, Company ABC's stock price rises to $115, the option holder can exercise their right to buy the stock at $105 and immediately sell it at the market price of $115, realizing a profit (minus the initial premium paid). Conversely, if the stock price remains below $105, the option would expire worthless, and the investor would lose the $3 premium. This example illustrates how the underlying's price directly determines the derivative's outcome.
Practical Applications
Underlying assets are integral to the functionality and utility of the broader financial market, particularly within the derivatives space. Their practical applications span various financial activities:
- Risk Management and Hedging: Companies and investors use derivatives based on underlying assets to mitigate potential losses from adverse price movements. For example, an airline might use futures contracts on crude oil to hedge against rising fuel costs, where crude oil is the underlying commodity. Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), oversee the derivatives markets, including security-based swaps and other contracts tied to underlying securities or commodities, to ensure market integrity and stability.20, 21 The SEC, for instance, has a regulatory framework for security-based swaps that are based on an underlying security, such as a stock or a bond.18, 19 The CFTC also provides educational materials explaining derivatives like options and futures, which are based on underlying commodities and financial instruments. [CFTC: A Primer on Option Trading]
- Speculation: Traders can speculate on the future price direction of an underlying asset without owning it directly, using derivatives to gain leverage.
- Price Discovery: The trading of derivatives can contribute to more efficient price discovery for the underlying assets, as market participants' expectations about future prices are reflected in derivative contract prices.17
- Portfolio Diversification: Derivatives based on various underlying assets, from different asset classes, can be used to achieve diversification strategies.16
Limitations and Criticisms
While underlying assets are essential for derivative markets, reliance on them presents certain limitations and criticisms. Derivatives can be complex, and their value often depends on several variables in addition to the underlying asset's price, making them difficult to value precisely. This complexity can obscure the actual risk involved, especially for less experienced investors.14, 15
One significant criticism centers on the potential for derivatives to amplify systemic risk within the financial system. The highly leveraged nature of many derivatives means that small movements in the underlying asset's price can lead to substantial gains or losses, potentially creating a domino effect if large participants default.12, 13 For example, the 2008 financial crisis brought increased scrutiny to the interconnectedness of derivative contracts, particularly credit default swaps, and their underlying assets. [Federal Reserve: New Approaches to Monetary Policy (Jerome Powell Speech)] Critics argue that this interconnectedness can spread instability throughout the financial markets.10, 11
Furthermore, the sheer size of the notional value of the global derivatives market, which can vastly exceed the value of the underlying assets, sometimes raises concerns about potential market instability, even if a significant portion of this value represents hedging activities.9
Underlying vs. Derivative
The terms "underlying" and "derivative" are intrinsically linked but refer to distinct financial concepts. An underlying is the fundamental asset, index, or benchmark whose value serves as the basis for a derivative contract. It is the real-world item, such as a stock, a quantity of oil, or an interest rate, that can be owned or directly traded in a cash or spot market.6, 7, 8
Conversely, a derivative is a financial contract whose value is derived from, or dependent on, the price movements and characteristics of that underlying.5 A derivative is not the asset itself but rather a contractual agreement to buy or sell the underlying asset, or to exchange cash flows based on its value, at a future date or under specific conditions. Unlike the underlying, a derivative does not have intrinsic value on its own; its worth is purely a function of its relationship with the underlying asset. For example, while Apple Inc.'s shares are an underlying stock, an option to buy Apple shares at a certain price by a certain date is a derivative.
FAQs
What types of assets can be an underlying?
A wide range of assets can serve as an underlying. Common categories include financial securities like stocks and bonds, commodities such as gold or crude oil, currency pairs, interest rates, and market indices like the S&P 500.2, 3, 4
How does the underlying affect the derivative's price?
The value of a derivative is directly influenced by the price movements of its underlying asset. If the underlying asset's price increases or decreases, the derivative's price will typically move in a corresponding direction, though not always proportionally due to factors like time to expiration and volatility.
Is it possible for an underlying to be another derivative?
Yes, in some complex financial structures, an underlying can indeed be another derivative. For example, an option on a futures contract has the futures contract itself as its underlying.
Why is understanding the underlying important for investors?
Understanding the underlying is crucial because it forms the foundation for evaluating the risk and potential return of any derivative investment. Without knowing the characteristics and potential price behavior of the underlying asset, it is challenging to properly assess the value or risks associated with the derivative contract.1