Derivatives are complex financial tools that might seem like a puzzle at first glance. Think of them as bets on the future value of something, but what's that "something"? Enter underlying assets, the foundation for options and futures.
In this guide, we’ll review the meaning of underlying assets, their various types, and an example to illustrate the concept. We’ll also discuss what financial derivatives are and list things that don’t qualify as underlying assets.
What is a derivative in finance?
Before diving into the fundamentals of underlying assets, let’s define derivatives in finance.
A derivative is any asset whose price is based on a different asset’s price, giving the derivative its underlying value. In other words, any change in the underlying asset’s value affects the derivative’s value. Most common derivatives include options, futures, forwards, and swaps.
Derivatives are useful for trading and speculation, hedging, and price discovery. However, their potential disadvantages include complexity, leverage, counterparty, and systemic market risks.
What are underlying assets?
An underlying asset is any asset from which a derivative contract, such as an option or futures contract, derives its value. A derivatives contract’s value is inextricably tied to an underlying asset’s value, meaning fluctuations in the underlying asset’s price sway the derivative’s value.
Two of the most common types of derivatives are options and futures.
Options
In an options contract, the contract buyer pays a premium to gain the right to buy or sell an asset at a specified price on or before a specified date. If conditions are unfavorable, the buyer can choose to let the contract expire rather than exercise their right to call the option.
In addition to price speculation, options help hedge existing positions in the underlying asset. For example, a trader may purchase an option to sell Bitcoin (BTC) at a specified price below the current value to offset losses if a market crash sends the spot price below the contract price.
Futures
Futures contracts work similarly to options, but they represent an obligation rather than a right. This means that the buyer or seller must buy or sell the specified asset at the specified price on the date outlined in the contract.
These contracts typically don’t involve premiums. Instead, they’re often based on commodities and can also be useful for hedging. For example, a soybean farmer can enter into a futures contract to lock in a minimum sale price per bushel, hedging against the possibility of a crash in soybean prices.
Types of underlying assets
Virtually any asset can be used as an underlying asset for a derivative. If it can be traded, there’s a derivative for it. Crypto has multiplied both the derivatives market’s size and the types of underlying assets that can be used.
Here are a few of the most popular underlying assets used in derivatives contracts:
Shares
Corporate shares are among the most common financial instruments. These commonly underlie options, futures, and equity swaps.
Bonds
Bonds are typically issued by corporations and governments to raise funding and are popular assets for use in derivatives contracts like bond options, futures, and interest rate swaps.
Currencies
Currency derivatives such as futures can allow speculating on or hedging against currency exchange rate changes.
In decentralized finance (DeFi), for example, stablecoins are usually pegged to national currencies by being backed by real units of the tracked currency held in reserve, as is the case of USDC.
Currencies are used in currency options, futures, swaps, and forwards.
Cryptocurrencies
Like any tradeable asset, cryptocurrencies can also underpin the value of derivatives contracts. Options and futures are common forms of crypto derivatives.
Indices
Indices track the overall price performance of baskets of securities. If the aggregate value of the underlying securities goes up, so does the index, and vice versa.
Futures, options, and swaps are popular choices for derivatives based on indices.
Real-world items
There’s a sense in which real-world assets can be used as underlying assets. For example, it’s possible to mint an NFT whose value is based on an underlying asset like a valuable painting or a piece of real estate. Since NFTs are publicly tradeable, efficient price discovery is possible.
Exchange-traded funds (ETFs)
An ETF is a publicly traded fund, and as an underlying asset, it can be used in ETF options, index futures, and index options.
Fun fact: Did you know that one of the most unusual underlying assets for a financial derivative was the weather? That's right.
Weather derivatives, introduced in the late '90s, use various weather-related indices, like temperature or rainfall, as their underlying assets. These instruments are primarily used by businesses whose revenue is significantly affected by weather conditions, such as agriculture, energy, and tourism industries. They provide a way for these companies to hedge against financial losses due to unfavorable weather conditions, turning the unpredictable nature of weather into a quantifiable financial risk that can be managed.
Example of an underlying asset
Although a broad range of assets can serve as underlying assets for derivatives, a particularly flexible example of an underlying asset is a cryptocurrency like Bitcoin.
Suppose a Bitcoin holder is mostly bullish about the prospects of their favorite cryptocurrency but believes there’s an outside chance of a crash within the next three months. To hedge against a crash, the holder may elect to purchase a three-month option contract at a $500 premium to sell 10 BTC at $35,000 each, 12.5% lower than the price of Bitcoin at the beginning of the contract.
If Bitcoin’s price drops below $35,000 on or before the three-month expiration date, the holder can exercise their option to sell at $35,000 to offset the dip in the value of their Bitcoin holdings.
What can’t be used as an underlying asset?
Not everything can qualify as an underlying asset––an item must be compatible with asset trading.
For example, items like personal property can’t be used as underlying assets because there’s no way to efficiently trade them and, therefore, no way to achieve price discovery. Intangible assets (like patents and brands) and perishable or difficult-to-store assets (such as fresh produce) are also poorly suited for use in derivatives.
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