- An underlying asset is the asset on which another financial instrument, such as a derivatives contract, is structured
- In the case of stock options, stock itself is the underlying asset
- Major types of underlying assets are financial claims, bonds, commodities, currency, ETFs and market index.
What is an Underlying Asset?
An underlying asset is the asset on which another financial instrument, such as a derivatives contract, is structured. Most often, the underlying asset is used in the context of derivatives pricing. For example, the call options contract on a company would have the company’s common stock as its underlying asset, furnishing the value for the options.
Types of Underlying Assets
The common types of underlying assets are:
· Financial Claims or Stocks
· Debt Securities
· Exchange Traded Funds
· Market Index
What are derivative contracts?
An option’s price is determined from the underlying asset’s price. The writer has to either sell or buy the underlying asset from the buyer on an agreed upon rate in an option contract. The buyer has the option to buy the underlying asset but is not obligated to do so. If the expiration date of the option is near and there has been no favourable movement observed in the underlying asset, the buyer has the option to let it expire but the buyer will lose the amount that he/she paid for the option.
Example of an Underlying Asset
In the case of stock options, stock itself is the underlying asset. For example, in a stock option to buy 200 shares of company A for $200, the stock of the company A is the underlying asset. The option’s value is determined by the underlying asset up till expiration. The option’s value may be affected if the value of the underlying asset fluctuates before expiration. Traders make their decision on whether to exercise trade or not depending upon the underlying asset’s value at a particular time.
It is also possible for the underlying asset to be a market index like S&P 500 or a currency. In such cases, the underlying asset includes the common stock in the market index.