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What is an Underlying Asset?
Underlying assets refer to the real financial assets upon which the price of a derivative is based. Thus, the price of the derivative is dependent on the price of the underlying. Any changes in the price of the underlying will be reflected in the price of that corresponding derivative.
The price of an underlying asset is often referred to as current market price or CMP. The market participants also interchangeably refer to CMP as spot price. Both terms essentially mean the same thing.
Underlying price or current market price or spot price is a fundamental component for calculating the price of a derivative. The underlying price or CMP is the last transacted price of the underlying security and often mirrors the true value or market price of the underlying asset.
Example of an Underlying asset
Let's understand what an underlying asset means in the stock market, with the help of an example. Reliance Industries Ltd (underlying asset of the derivative) is a company whose shares and futures (derivative) are both listed and traded on the exchange.
Now RIL futures are a derivative of RIL shares. In other words, RIL shares are the underlying assets. If RIL shares are currently trading at ₹2,600 and RIL futures are trading at ₹2,605 the difference between the price of underlying security and futures is called “basis”.
Basis = Futures prices of underlying security - Spot price of underlying security
The basis or the spread between underlying security price and the corresponding derivative can be positive, negative or zero. The difference between the futures and spot prices is generally positive. This gap tends to reduce as the contract moves closer to expiry. However, on expiry the futures price will always converge on the spot price of the underlying.
Let’s look at scenarios and understand how an underlying asset and its derivative contract works
Scenario 1: RIL quarterly results were announced and its revenue increased by 20%. After this announcement, RIL shares rallied to ₹2,650 from previous levels of ₹2,630 in cash segment and RIL futures edged up higher at ₹2,655 compared to the pre result level of ₹2,635
Scenario 2: RIL quarterly results were announced and its revenue decreased by 20%. After the announcement, RIL share price declined ₹2,610 from the previous level of ₹2,630 in the cash segment. While the RIL futures softened in price to trade at ₹2,615 against the level of ₹2,635, which was the pre-result announcement level.
In the above scenarios, the price of the RIL futures moved in the same direction as that of RIL shares. This is because RIL shares are the underlying. Any change of price in underlying shall be mirrored by futures in terms of price direction, momentum and proportion.
Types of underlying assets
Here's the list of underlying assets and the risks associated with them.
- Stocks: Stock is another word for share. Stocks are subject to market risk, balance sheet risk and general economic risk factors as their price is dependent on fundamentals as well as the market forces of demand and supply.
- Indices: Indices refer to indexes like Nifty50, Bank Nifty, Nifty Midcap50, India VIX etc. These too are subject to market risk and general economic risk. Their prices too are dependent on the market forces of demand and supply.
- Currencies: Currencies refer to the legal tender used in various countries around the world like Rupee (₹), Euro (€), etc. These are subject to interest rate risk, geo-political risk and sovereign debt risk. E.g. USD/INR, GBP/INR, EUR/USD, etc.
- Bonds: Bonds are a type of debt; a financial instrument used to lend money. They are subject to default risk, interest rate risk, and counterparty risk. For eg: T-Bills, G-Sec (Indian Government Security), LIBOR, etc.
- Commodities: Commodities include perishables like fresh fruits, non-perishables like nuts and seeds, (bullions) precious metals like gold, silver etc. Commodities are also subject to market risk and general economic risk as their price is dependent on the market forces of demand and supply.
Indian stock market perspective
In the Indian stock market, futures and options are the most widely traded derivatives.
A futures contract is a type of standardized derivative contract that derives its value from the underlying asset. It is a contract between two parties to buy or sell an asset at a predetermined price and quantity or amount on a specified future date.
Most commonly traded futures are those with stock and indices as their underlying. E.g. Reliance Industries Ltd futures are dependent on Reliance Industries Ltd shares and Nifty50 futures are dependent on the Nifty50 index.
Indian stock markets enable trading in a series of monthly and weekly contracts. The futures contracts are limited to just 3 months by the nature of exchange regulation. They are distinguished on the basis of expiry, as follows:
- Near month
- Next month
- Far month
Future contracts on stocks have monthly expiry. All expires are stipulated by exchanges and happen on the last Thursday of every month. If last Thursday is a holiday, then the expiry and settlement shall happen on the previous day.
Futures aren't the only derivatives that are traded on the exchange. Another type of widely traded derivatives that exist are options.
An option buyer or holder has the right but not the obligation to buy (call option holder) or sell (put option holder) the underlying security at a predetermined price on or before a predetermined date. Similarly, an option seller or writer of the options has the obligation to buy (put option seller) or sell (call option seller) the aforementioned underlying security at the predetermined price when the buyer of the options (both call and put) chooses to exercise the option.
There are two types of options, call and put. These options are based on stocks and indices.
See examples below:
The stock options only have monthly expiry which are scheduled on the last Thursday of every month. Option expiry on indices and futures are stipulated on a weekly and monthly basis. The weekly option expires every Thursday.
Like the series of future contracts, the option contracts also replicate the same series of three successive calendar months and use the same terms of current month, near month and far month.
The weekly index options that expire every Thursday are termed as near week contract, next week contract and far week contract.