An underlying asset is a financial term used to describe the financial product upon which a derivative’s price is based. It could be a variety of items including stocks, bonds, currencies, commodities, indexes, or interest rates. Essentially, the underlying asset is the focal point from which derivatives gain their value. When you buy a derivative, you are not actually purchasing the underlying asset, but instead, acquiring a contract that represents the underlying asset. That contract is what gives you the rights to the valuation of the underlying asset.
Related Questions
1. How do underlying assets work in the stock market?
In the stock market, underlying assets often refer to the shares of a specific company. For example, if you were to buy an option contract for Apple Inc., the underlying asset would be Apple’s stock. The performance of this stock influences the value of your derivative contract.
2. What is a derivative in finance?
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A derivative is a financial contract that derives its value from an underlying asset. Derivatives are primarily used for hedging risk or for speculation. Common types of derivatives include futures, options, forwards, and swaps.
3. What is considered a commodity in finance?
A commodity in finance is a basic good used in commerce that’s interchangeable with other goods of the same type. These often include materials like gold, oil, wheat, or natural gas which are used in the production of goods or services.
4. How does an index work as an underlying asset?
An index can work as an underlying asset through index futures or options. For example, if you have an option contract on the S&P 500 index, the index itself acts as the underlying asset. The derivative’s value fluctuates based on the overall performance of the S&P 500 index.
5. Can currencies act as underlying assets?
Yes, currencies can certainly act as underlying assets, especially in the hedging and speculation of foreign exchange rates. Forex derivatives are contracts whose value is tied to the exchange rate of two currencies, making those currencies the underlying asset for that contract.