Underlying asset is a financial instrument or a physical commodity that serves as the basis for a financial derivative. In this article, let us delve deeper into the subject with examples.
Table of Contents
Introduction
In the financial market, an underlying asset is a financial instrument or a physical commodity that serves as the basis for a financial derivative. The asset could be stocks, indices, currencies, or commodities. The derivative contracts are then traded on the exchange and are based on the underlying asset. In this article, we will discuss the concept of an underlying asset, its importance, and examples.
What is an Underlying Asset?
An underlying asset is a financial instrument or a physical commodity that serves as the basis for a financial derivative. In simple terms, it is an asset on which a derivative contract is based. The derivative contract’s value is derived from its value, and any change in the underlying asset’s value affects the derivative contract’s value.
The asset could be stocks, indices, currencies, or commodities. For example, if an investor wants to buy a call option or trade a futures contract on the Nifty 50 index, the Nifty 50 index is the underlying.
Importance
Its importance can be understood by looking at the derivative market’s size in India. Just to give an idea of the market size, according to the Securities and Exchange Board of India (SEBI), the total turnover of the Indian derivative market was Rs. 1.45 Lakh Crore in February 2021. The derivative market’s size is significant, and any movement in the underlying asset’s price can have a significant impact on the derivative contract’s value.
Types of Underlying Assets
Stocks
Stocks are one of the most common underlying (assets) in the Indian derivatives market. The derivative contracts on stocks could be futures or options. The derivative contracts on stocks are traded on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).
For example, if an investor wants to buy a call option or a futures contract on Reliance Industries Limited (RIL), RIL is the underlying.
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Indices
Indices are a basket of stocks that represent the performance of a particular segment of the stock market. In the Indian derivatives market, the derivative contracts on indices could be futures or options. The derivative contracts on indices are traded on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).
For example, if an investor wants to buy a call option contract on the Nifty 50 index, the Nifty 50 index is the underlying asset. If an investor wants to buy a futures contract on the Bank Nifty index, the Bank Nifty index is the underlying.
Also read: Nifty 50 – Its formation & weightages
Currencies
Currencies are one of the most actively traded underlying assets in the Indian derivatives market. The derivative contracts on currencies could be futures or options. The derivative contracts on currencies are traded on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).
For example, if an investor wants to buy a call option contract on the USD/INR currency pair, the USD/INR currency pair is the underlying asset.
Commodities
Commodities are physical goods that are traded in the market. The derivative contracts on commodities could be futures or options. The derivative contracts on commodities are traded on the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).
For example, if an investor wants to buy a option or a futures contract in Gold, Silver, Crude Oil etc., the concerned commodity is its underlying asset.
Also read: What is Free-Float market Capitalization – complete details
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