You may have come across terms like options, futures, or exchange-traded funds (ETFs) while learning about investing and trading. In many of these discussions, you’ll often hear the phrase “underlying asset.” An underlying asset is the actual financial instrument that a derivative or product is based on. It could be a commodity like gold, a stock such as XYZ, or even a market index like the Nifty 50.
In this blog, we’ll explain what underlying assets are, why they matter, and the different types you’re likely to encounter as an investor or trader.
Underlying Asset : An Overview
An underlying asset is the financial instrument on which a derivative’s value is based. It might be a currency, an index like the Nifty 50, a stock, or even a commodity like gold. The price of a derivatives contract, such as a stock option or futures contract, is therefore determined by the value of the underlying asset.
Example: Let us say you bought a call option of a stock named ABC Industries. The value of that option is derived from ABC’s actual stock. Thus, the underlying asset is the ABC’s shares. Your option increases in value if the stock price rises.
Read Also: What is Derivatives?
Why are Underlying Assets Important?
1. They Add Value to Financial Products
Suppose the underlying asset is similar to an automobile’s engine. The entire structure is powered by it. An option on XYZ stock or a gold future only has value because it is tied to the stock or gold itself. Without the underlying, the derivative contracts are worthless.
2. They Help You Understand Risks
The behaviour of various assets varies. While some, like gold or bonds, move more slowly, others, like stocks, fluctuate a lot. By understanding the underlying asset, you can better gauge volatility, risk exposure, and whether the derivative product associated with it fits your comfort zone or not.
3. Used to Value Derivatives Contracts
If you trade options or futures, this is a crucial one. The reason those derivatives contracts exist is because they are linked to the underlying, which is a real asset. That asset, whether it be a stock, index, wheat, or crude oil, is what gives the derivative contract its value.
4. They Allow You to Hedge
Underlying assets also make hedging possible. A farmer worried about wheat prices falling, or an investor concerned about a market downturn, can use futures or options contracts to lock in prices and reduce risk.
Characteristics of the Underlying Assets
1. Liquidity
Essentially, liquidity refers to how simple it is to buy or sell something. Large-cap stocks are generally liquid. Usually, you can buy or sell in a matter of seconds. However, there might not be many buyers or sellers for lesser-known assets, so you might be compelled to wait or accept an unfavourable price.
2. Volatility
Volatility measures how much an asset’s price moves over time. High volatility means larger price swings, which create both higher risk and greater potential rewards. Low volatility signals more stable prices and slower, steadier growth. Understanding volatility is especially important when trading derivatives like options or futures, since their value is directly influenced by price fluctuations in the underlying asset.
3. Transparency
You want assets that provide transparency, where prices, trading volumes, and related news are easily accessible in real time. Stocks, gold, and major currency pairs are usually clear and easy to track. However, if you are dealing with less common instruments that trade in obscure or illiquid markets, it is best to be cautious.
Types of Underlying Assets
Now that we have a clear understanding of underlying assets and their significance, we will examine the various kinds that you will come across in everyday life. You may already be familiar with some of these; in fact, you may have invested in them without even knowing they act as underlying assets to their respective derivative contracts.
1. Stocks
Shares, also known as stocks, are undoubtedly the most common underlying asset available. When you buy stock options or trade stock futures, you are making a bet on the price movement of the underlying stocks.
Example: If you buy a call option on XYZ stock, then XYZ stock is your underlying. Therefore, your option gains value if the stock price rises.
2. Commodities
These are tangible goods that are traded on exchanges, such as wheat, oil, or gold via derivative contracts. Futures contracts are frequently used by traders to buy or sell them at a fixed rate at a later date.
For instance, gold is the underlying asset for gold futures & crude oil contracts fluctuate in line with the oil price movements.
3. Currency
In the forex market, the most common underlying assets are currency pairs such as USD/INR or EUR/USD. These are especially important for importers, exporters, and international investors who need to manage currency risk.
For example, the value of a USD/INR futures contract is determined by the exchange rate between the US dollar and the Indian rupee.
4. Market Indices
Instead of trading individual stocks, you can trade entire indices such as the Sensex or Nifty 50. This approach is useful if you want exposure to overall market trends without having to pick specific stocks.
For example, when you buy a Nifty 50 option, the index itself serves as the underlying asset.
5. Bonds & Interest Rates
Even government or corporate bonds and interest rates can be underlying assets. These are usually used in more technical products like interest rate swaps or bond futures.
For instance – A 10-year government bond future gets its value from—you guessed it—the 10-year G-Sec.
Underlying Asset vs Derivative Contracts
| Feature | Underlying Asset | Derivative |
|---|---|---|
| What it is | The actual asset (stock, gold, etc.) | A contract based on the underlying asset |
| Value comes from | Its price in the market determined by buyers and sellers | The price of the underlying asset and buyers and sellers of derivative contract |
| Examples | Stocks, gold, currencies, bonds | Futures, options, swaps, forwards |
| Ownership | You own the real asset | You own a right/obligation, not the asset |
| Risk level | Depends on asset type | Usually higher due to leverage and time constraints |
Risks Associated with Underlying Assets
1. Price fluctuations
Markets can be unpredictable. Prices of stocks, gold, oil, or even currencies can move up and down significantly for a number of reasons. Your investment returns may suffer if your underlying asset moves in the wrong direction.
Consider the following scenario: You bought a call option anticipating a rise in XYZ stock, but the price of the stock falls instead. Your option may suddenly lose most or all of its value.
2. Risk to the Market
High volatility during recessions, wars, or global financial crises can bring everything down, even if your chosen investment is fundamentally sound. It is important to consider the larger picture rather than just your investment.
3. Issues with Liquidity
Some assets are more difficult to buy or sell quickly. It could be difficult to find a buyer quickly when you need to sell something that you own, which could mean accepting a price that is less than what you expected.
For example, certain niche commodities or small-cap stocks may seem attractive at first, but when it comes time to sell, they can turn out to be highly illiquid and difficult to exit.
Conclusion
Simply put, an underlying asset is the real asset that gives value to financial instruments such as futures, options, exchange-traded funds, and more. Knowing the characteristics of the asset that lies “underneath” your derivative contracts, such as a stock, commodity, or even an index, can help you make better investment and trading decisions.
It can make a significant difference to know what you are betting on, including its expected movement, liquidity, and news sensitivity. The underlying asset determines the risks and rewards you are taking on, regardless of whether you are trading more actively or making long-term investments.
Frequently Asked Questions (FAQs)
Is the asset always a stock?
No, underlying assets can be stocks, bonds, currencies, commodities, or even interest rates.
Are all underlying assets bought and sold on stock exchanges?
A lot of them are, but not all of them. Some underlying assets, like interest rates, cannot be traded directly.
Is gold a real asset?
Yes, gold is a great example. There are a lot of derivatives, ETFs, and even mutual funds that are based on it.
Why do I need to consider the underlying asset before trading?
Because the underlying asset determines the risk, volatility, and potential returns of your trade. Its price movements, liquidity, and behavior directly impact how your trading position will perform and whether it aligns with your expectations.
How do I find the asset that an investment product is based on?
The product details or fact sheet usually have these details. Always check before investing.
