Underlying Asset

A security that has a derivative contract based on it.

The financial term "underlying asset" is used to describe a security that has a derivative contract based on it. The underlying asset within a trade is the basis for the value of the derivative contract. 

Underlying asset

It can be referred to as what creates the value of the particular derivative contract. It also supports the security within the contract that both parties have agreed to exchange.

For example, suppose a company's stock was considered when a call option was issued (to bet the stock will rise) on ticker WSO for a strike price of $200. In that case, the investor can purchase 100 shares (usually) for that price at any time during the contract's length. 

In this scenario, WSO is the underlying asset, and the call option is the derivative contract. Therefore, if WSO reaches $210, the investor may exercise their strike price of $200 for a $1000 gain.

Derivative Contracts Relation to Underlying Assets

The two terms have a direct correlation with each other. Investors will incorporate derivative strategies into their trades to increase leverage or to hedge risk within a position. 

derivative contracts

A derivative contract is a contract used within trading whose value is derived from the underlying asset. Derivatives are important to understand as they are the contracts issued upon an asset, creating the meaning behind the term. 

Various derivative contracts are used to perform different types of advanced trades, each containing its own level of risk. 

These are two important derivative classes to understand:

  • Lock derivative: A lock derivative 'locks in' both parties of the contract, making them obligated to bid by the agreed price and length of the contract. Examples of lock derivatives are swaps, futures, and forwards. 

  • Option derivative: An option derivative allows the purchaser of the option to execute their trade whenever desired, without obligation. At the end of the contract, the purchaser can choose whether they would like to execute the trade or not. Examples include put and call option contracts. 

Types of Underlying Assets Used with Derivatives

There are many variations; therefore, specific derivatives are used depending on the asset type. The most popular examples would be: 

  • Stocks 
  • Commodities
  • Bonds 
  • Currencies

1. Stocks

One of the most common classes is company stock. A derivative contract is formed between the buyer and the seller that allows the buyer the option to buy/sell the stock on a given date at an agreed-upon price. 

Money

There are two variations: a call option (betting the stock will go up) and a put option (betting the stock will go down). 

2. Commodities

Commodities are basic raw materials used for the manufacturing and use of goods and services. 

Commodities

Types of commodities to be considered: 

  • Gold
  • Oil
  • Coffee beans, 
  • Wheat

In recent years commodities have been used more often as underlying assets, as derivatives have become more known. 

Commodities are likely to be used within future and forward contracts as well.

3. Bonds

A bond is a loan contract, transacting a sum of funds from the investor to the borrower, then given back on a set date with interest; practically, a glorified "IOU." Bonds are often used as an underlying asset to convertible, callable, and puttable bonds.

4. Currency

Currency is the medium of exchange that one would use to purchase goods and services, but it can also be traded. 

A more common term when trading currency is forex (foreign exchange), where investors exchange one currency for another. Currency acts as the underlying asset within forward and future derivative contracts, similar to commodities, with the exchange rates varying. 

Example

In a scenario involving a commodity as the underlying asset, let's discuss how an oil company could incorporate derivatives when selling its goods. 

Oil

For instance, the global affairs of Russia and Ukraine's impact on oil prices have caused the market for oil to become very inflated. An oil company may take advantage of these high prices before they begin to drop. 

The company may use a forward contract to lock in the current price (spot price) of, say, $100 per barrel, hoping that the price now will be greater than the future price. They are now guaranteed $100/barrel no matter how the future price swings. 

The company has a lock derivative contract to sell 100,000 barrels of oil at the agreed-upon price. Whether the future price of oil is greater or less than the agreed-upon price will determine the company's profit/loss from the trade.

 At the end of the contract, there are three possible outcomes:

  1. The company was correct, and the price of oil now is $70, $10 more than the contract price. The other party of the contract will pay the oil company the difference between the prices: ($10(100,000))= $1,000,000 profit.
  2. If oil sees a rise in price to 110, the company will lose the difference to the counterparty. In this case, a $1,000,000 loss.
  3. Finally, if oil doesn't change in price, nothing is exchanged, and the contract will be closed.

Underlying Asset vs. Underlying Security

Both the terms have very similar traits; however, the terms are not entirely interchangeable. The two terms both describe the base investment a derivative is placed upon; however, that base is different for each term. 

The reason for this difference is that not all assets are securities. 

Underlying asset vs. security

Securities: A security describes a selection of financial assets, each of which holds some type of monetary value. The three main types of securities are equity/stocks, debt/bonds, and a mixture of the two called hybrid securities: preferred stocks and convertible bonds

All securities are and can be referred to as assets. Referring to the stock WSO, it can be defined as an underlying asset or security; however, a commodity, like wheat, would only be referred to as an underlying asset. 

Assets: The term asset defines any resource with economic value owned for the investor's future gain. The term asset is much broader than securities, containing fixed, financial, and intangible assets.

  1. Fixed Asset: Assets with an expected life greater than a year are labeled as fixed assets, e.g., buildings, machinery, and vehicles. 
  2. Financial Assets: Financial assets are investments in the assets and securities of other companies, including stocks, bonds, equity, and hybrid securities. 
  3. Intangible Assets: Intangible assets have no physical aspects. This includes patents, trademarks, and goodwill.

The most common type of asset used within derivative contracts is financial assets. Listed above, stocks, commodities, bonds, and securities are most commonly used as the underlying asset to option, future, and forward contracts. 

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Researched and authored by Thomas Fallows | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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