What is an Underlying Asset?

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What Are Underlying Assets

Underlying assets are like the real things that give value to financial bets. To understand underlying asset meaning, when we bet on something in the financial world, we’re actually betting on these real things. If the real thing’s value changes, the bet’s value changes too.

The price of the real thing is often called the “current market price” or “CMP.” People also call it the “spot price,” but it means the same thing. This price is crucial for figuring out how much our financial bet is worth. The current market price is basically the last price at which the real thing was bought or sold, and it shows the real value of that thing in the market.

Understanding Underlying Assets with an Example

To grasp the concept of underlying assets in the stock market, let’s take a closer look using the underlying assets example. Reliance Industries Ltd (RIL) serves as our example, and it’s both a company with shares and a futures contract listed and traded on the stock exchange.

Here, RIL shares are the underlying assets, and RIL futures are a derivative linked to those shares. If RIL shares are currently trading at ₹2,600, and RIL futures are trading at ₹2,605, the difference between the price of the underlying shares and the futures is called the “basis.”

Basis = Futures prices of underlying shares – Spot price of underlying shares

This basis, or the difference between the underlying security price and its corresponding derivative, can be positive, negative, or zero. Typically, this difference is positive and tends to decrease as the futures contract gets closer to its expiration date. However, upon expiry, the futures price will always converge with the spot price of the underlying shares.

Let’s explore a couple of scenarios to understand how the relationship between an underlying asset and its derivative contract works:

Scenario 1: After RIL announced its quarterly results, with a 20% increase in revenue, RIL shares rose to ₹2,650 from their previous level of ₹2,630 in the cash segment. Simultaneously, RIL futures increased to ₹2,655 compared to their pre-result level of ₹2,635.

Scenario 2: In this scenario, RIL’s quarterly results revealed a 20% decrease in revenue. Consequently, RIL share prices dropped to ₹2,610 from the earlier level of ₹2,630 in the cash segment. RIL futures also decreased in price, trading at ₹2,615 compared to their pre-result level of ₹2,635.

In both scenarios, you’ll notice that the price of RIL futures moved in the same direction as RIL shares. This alignment happens because RIL shares are the underlying assets. Any changes in the price of the underlying shares are mirrored by the futures in terms of price direction, momentum, and proportion.

Also Read: Reliance Industries Share Price

Categories of Underlying Assets and Their Risks

Let’s explore the various types of underlying assets and the associated risks:

1. Stocks

These are essentially shares of companies. Stocks are exposed to market risk, balance sheet risk, and general economic risk. Their value depends on both fundamental factors and market dynamics, influenced by the interplay of supply and demand.

2. Indices

Indices, such as Nifty50, Bank Nifty, Nifty Midcap50, and India VIX, also face market risk and general economic risk. Their prices are determined by market forces, reflecting the balance of supply and demand.

3. Currencies

Currencies represent the legal tender of different countries, like the Rupee (₹) and Euro (€). These currencies are susceptible to interest rate risk, geopolitical risk, and sovereign debt risk. For example, pairs like USD/INR, GBP/INR, and EUR/USD exhibit these characteristics.

4. Bonds

Bonds are a form of debt, used to lend money. They come with default risk, interest rate risk, and counterparty risk. Examples include T-Bills, G-Sec (Indian Government Security), and LIBOR.

5. Commodities

This category encompasses a wide range of items, from perishable goods like fresh fruits to non-perishables like nuts and seeds, as well as precious metals like gold and silver. Commodities are also exposed to market risk and general economic risk, with their prices influenced by the ebb and flow of supply and demand.

Understanding Options: Basics and Key Terms

On a predetermined date, an option seller, also known as the writer of options, bears the responsibility to either purchase (in the case of a put option seller) or sell (in the case of a call option seller) the underlying security at the agreed-upon price when the options buyer decides to exercise their choice.

Options come in two main categories: call options and put options, and they are tied to stocks and indices. Some examples include stocks like RIL, TCS, ITC, and INFY, along with indices such as Nifty50 and Bank Nifty.

For stock options, expiry dates occur monthly and are set for the last Thursday of each month. Index and futures options have scheduled weekly and monthly expirations, with weekly options concluding every Thursday.

Similar to the structure of future contracts, option contracts also follow a pattern of three consecutive calendar months. They employ the same terms, consisting of the current month, near month, and far month.

Also Read: Tata Consultancy Services Share Price

Connection between Underlying Assets and Derivatives

The relationship between underlying assets and derivatives is anchored in the fact that derivatives draw their worth from these fundamental assets via predefined contracts or agreements. Alterations in the value of the underlying asset have a direct impact on the price or performance of the derivative. For example, in an options contract, you possess the option to buy or sell the asset at a predetermined price within a specified timeframe.

Similarly, when you invest in a futures contract linked to a commodity like oil, the underlying asset is the tangible oil itself. The value of the futures contract is intricately tied to fluctuations in the oil market. As oil prices rise, the contract’s value increases in tandem, and conversely, when oil prices decline, the contract’s value decreases.

Also Read: Bond Market vs Stock Market

Importance of Underlying Assets

Comprehending the significance of underlying assets holds paramount importance for participants in derivatives markets, be they investors or traders. Through a comprehensive examination of the attributes and trends of the underlying asset, individuals in these markets can make well-informed choices regarding their derivatives transactions.

The role of underlying assets is pivotal in the realm of risk management. Enterprises such as airlines and manufacturers that rely on commodities can employ derivatives to shield themselves from price fluctuations. By fixing future purchase prices, these firms can effectively mitigate the potential hazards associated with abrupt spikes in commodity prices.

In summary

Derivative contracts derive their value from underlying assets, which can encompass various assets such as stocks, commodities, currencies, bonds, or indices. The interplay between derivatives and these foundational assets is crucial for investors seeking to control risk, engage in price speculation, or tap into particular market dynamics.

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