Underlying contract

An underlying contract refers to the asset or financial instrument upon which the value of a derivative contract is based within the broader Derivatives Market. It represents the actual commodity, security, currency, or other financial benchmark that must be delivered or exchanged when a derivative contract matures, or whose price movement determines the derivative's payoff. The underlying asset is the fundamental element that gives the derivative its value and purpose.

History and Origin

The concept of an underlying contract, particularly in the context of futures, dates back to ancient agricultural practices where farmers would agree to sell their crops at a later date to secure a stable price. This early form of forward contracting provided a measure of security against unpredictable market conditions. The modern evolution of this concept can be traced to 17th-century Japan with the Dojima Rice Exchange, often considered the world's first formal futures market, where rice was the underlying commodity.⁴,³

In the United States, the Chicago Board of Trade (CBOT) was established in 1848 to facilitate grain trading, helping farmers and merchants hedge against price volatility by standardizing contracts for agricultural products like corn and wheat.² By the 1970s, the scope of underlying assets expanded significantly beyond commodities to include financial instruments such as stocks, bonds, currencies, and interest rates, marking a new era for derivative markets.¹

Key Takeaways

An underlying contract is the asset or benchmark that a derivative contract derives its value from.
It can include physical assets like commodities, or financial assets like stocks, bonds, currencies, and indices.
The price movements of the underlying contract directly influence the profitability or loss of the associated derivative.
Understanding the characteristics of the underlying contract is crucial for evaluating and managing derivative positions.
Derivative contracts referencing an underlying contract are used for purposes such as hedging risk and speculation.

Interpreting the Underlying Contract

The underlying contract is central to understanding any derivative. Its characteristics—such as its volatility, liquidity, and supply and demand dynamics—directly impact the pricing and behavior of the associated derivative. For instance, a highly volatile underlying asset will generally lead to more expensive options contracts due to the increased probability of large price swings. Similarly, the liquidity of an underlying contract affects how easily the derivative can be traded and whether its price accurately reflects market conditions. Traders and investors must thoroughly analyze the underlying asset to anticipate potential movements and assess the risks and opportunities presented by the derivative.

Hypothetical Example

Consider an investor who believes the price of XYZ Corp. stock, the underlying contract, will rise in the coming months. Instead of buying the stock directly, they decide to purchase a call option on XYZ Corp. stock.

Here's how the underlying contract functions in this scenario:

Underlying Asset: XYZ Corp. stock. Its current market price is, for example, $100 per share.
Derivative: A call option contract on XYZ Corp.
Terms: The option gives the holder the right, but not the obligation, to buy 100 shares of XYZ Corp. stock at a strike price of $105 per share, expiring in three months.
Outcome:
- If, at the expiration date, XYZ Corp. stock rises to $115 per share, the investor can exercise their option to buy shares at $105 and immediately sell them in the market at $115, profiting from the $10 per share difference (minus the option premium paid). The appreciation of the underlying contract (XYZ Corp. stock) directly led to the option's profitability.
- If XYZ Corp. stock falls to $95 per share, the option would expire worthless, as it makes no sense to buy at $105 when the market price is $95. The decline in the underlying contract's value resulted in the option's loss.

This example illustrates how the value and outcome of the derivative (the call option) are entirely dependent on the price movement of its underlying contract (XYZ Corp. stock).

Practical Applications

Underlying contracts are fundamental to the operation of global financial markets, serving as the basis for a vast array of derivative products. Their practical applications span various aspects of finance:

Risk Management (Hedging): Businesses and investors use derivatives to hedge against adverse price movements in their underlying assets. For example, an airline might use futures contracts on crude oil to lock in fuel costs, where crude oil is the underlying contract.
Speculation: Traders engage in speculation by taking positions on derivatives based on their forecasts for the future price of an underlying contract, aiming to profit from anticipated movements.
Price Discovery: The active trading of derivatives tied to an underlying contract can contribute to more efficient price discovery for the underlying asset itself, reflecting market participants' collective expectations.
Arbitrage: Discrepancies between the price of a derivative and its underlying contract can create arbitrage opportunities, prompting traders to simultaneously buy the undervalued asset and sell the overvalued one to profit from the price difference.
Market Oversight: Regulatory bodies like the Federal Reserve monitor the derivatives markets and their underlying assets to maintain financial stability. The Federal Reserve, for instance, provides supervisory guidance related to banks' investment and derivatives activities, which inherently involve underlying contracts.

Limitations and Criticisms

While underlying contracts are essential to derivatives, reliance on them presents certain limitations and criticisms:

Complexity and Opacity: The relationship between a derivative and its underlying contract can be complex, especially with exotic derivatives or those tied to multiple underlying assets. This complexity can lead to a lack of transparency, making it difficult for some market participants to fully understand the risks involved.
Systemic Risk: A sudden and significant decline in the value of a widely used underlying contract, or a disruption in its market, can trigger widespread losses across the derivatives market. This was exemplified during the 2008 financial crisis, where the underlying mortgages and mortgage-backed securities contributed to the collapse of institutions heavily invested in credit default swaps tied to these assets. The complexity of these derivatives and their underlying assets was a significant factor in the crisis.
Leverage Amplification: Derivatives often involve high degrees of leverage, meaning small movements in the price of the underlying contract can lead to large profits or losses for derivative holders. This amplifies both gains and risks, making positions potentially volatile.
Counterparty Risk: While standardized exchange-traded derivatives (like futures and options) minimize counterparty risk through clearinghouses, over-the-counter (OTC) derivatives, particularly forwards and certain swaps, carry the risk that one party to the contract may default.

Underlying Contract vs. Derivative

An underlying contract is the fundamental asset or financial instrument that a derivative derives its value from. It is the real-world item—be it a share of stock, a barrel of oil, a specific currency pair, or an interest rate benchmark—that is either physically traded, held, or whose price fluctuations are observed. The underlying contract exists independently of the derivative.

In contrast, a derivative is a financial contract whose value is derived from the price performance of its underlying contract. It is not the asset itself but a claim or obligation related to that asset. Derivatives allow investors to gain exposure to the price movements of an underlying contract without directly owning it. For example, buying a futures contract on gold gives exposure to gold's price without physically possessing the metal. The primary distinction is that the underlying contract is the source of value, while the derivative is the instrument whose value is contingent upon that source.

FAQs

What types of assets can be an underlying contract?

An underlying contract can be nearly any measurable asset or benchmark. Common examples include stocks, bonds, commodities (like crude oil, gold, or agricultural products), currencies, market indices (like the S&P 500), and even interest rates or economic data.

How does the underlying contract affect the derivative's price?

The price of a derivative is highly sensitive to changes in the price of its underlying contract. As the underlying asset's price moves, the value of the derivative will typically move in a correlated fashion, though not always one-to-one due to factors like time to expiration, volatility, and strike price for options.

Can an underlying contract be something intangible?

Yes, an underlying contract does not have to be a physical asset. It can be an intangible financial benchmark, such as an interest rate index (e.g., SOFR or LIBOR for swaps), or an equity index like the Nasdaq 100. The key is that its value can be quantitatively measured and tracked.

Is the underlying contract always delivered when a derivative expires?

Not always. While some derivatives, like certain futures contracts, may result in physical delivery of the underlying commodity, many are cash-settled. This means that at expiration, instead of exchanging the physical underlying asset, the difference between the contract price and the market price of the underlying is paid in cash. Options contracts, if exercised, might result in the delivery of the underlying shares, or they can be cash-settled depending on the contract terms.