An underlying asset is a financial term for the asset on which a derivative’s value is based. It can be anything with value, such as stocks, bonds, commodities, currencies, interest rates, or market indexes. In the context of derivatives like options and futures, the underlying asset is the item the derivative contract allows you to buy or sell. For example, in a stock option contract, the underlying asset is the specific stock the option pertains to. The value and price movements of the underlying asset directly influence the value of the derivative.Â
A farmer who grows corn has a natural long position in corn. That farmer may want to lock in a price for [their] corn at harvest instead of simply waiting and seeing what the market price will be at the time [the farmer] harvests the corn. In that case, the farmer might sell corn in the futures market, guaranteeing the price [they] will receive.
If, at the time of harvest, the price of corn is lower than that at which [the farmer] contracted to sell, [they] would have won by selling the futures contract. If the price is higher, [they] would have been better off not selling corn futures and [getting the] higher market price.
Dr. Robert R. Johnson, finance professor at Creighton University’s Heider College of Business, on how underlying assets work.
In Simpler Terms
Think of buying a ticket for a concert. The value of the concert ticket depends on the popularity and demand for the artist (the underlying asset). If the artist becomes more popular, the demand for concert tickets increases, just like the value of a derivative increases as the value of its underlying asset goes up. The concept of underlying assets isn’t just limited to financial markets. It’s a principle that can be seen in various aspects of life, where the value of one thing is dependent on another.
