Underlying assets refer to any asset or valuable commodity which determines the value of a derivative based upon the asset. This term is frequently and importantly utilized to discuss derivatives trading. Options are a good example of this. Derivatives themselves prove to be financial instruments that investors trade. Their price is derived from the asset that underlies them. This underlying asset will be the investible instrument like an individual stock, a stock market index, a currency or currency pair, a commodity, or futures. The price of the derivatives will be based upon these.
Options for a given stock provides the holder of the option with the right (but not the obligation) to purchase or sell the stock at a certain strike price (a given price point) on a particular date at some expiration point (a future date that is predetermined). In the case of an option, the underlying assets will always amount to the stock of the company in question.
This underlying asset helps to identify the financial instrument in the agreement that gives the contract its value. Investors in such a contract will always have the right, or option, to purchase the underlying assets for a pre-arranged price on the expiration date. The asset that underlies the contract provides the security of the agreement itself. The two trading parties consent to exchange the underlying asset if necessary as a contract clause in the derivative agreement.
Famed and legendary investor Warren Buffet has notoriously and correctly declared such derivatives to be “financial weapons of mass destruction.” This proved to be the case in the Global Financial Crisis of 2008-2009. A wide range of derivatives based on shaky underlying assets literally blew up the world economy and banking system in financial carnage that is still reverberating throughout the economies of the world nearly ten years later.
Take some real world examples that will help to clarify the complex ideas. Berkshire Hathaway sells stock market index put options on worldwide stock market indices that range from the FTSE 100 in London to the American-based S&P 500. These options are unusual because the do not have an expiration date until the years ranging from January of 2018 to January of 2026. On those particular dates of the varying contracts, it will be the underlying assets of the relevant stock market indices which will decide the amount of money that Berkshire pays out to the option holders.
In theory, the indices could approach zero, though this is highly unlikely. Yet Berkshire Hathaway would be forced to come out of pocket to the amount of up to $27.6 billion to these put holders if they did. When Berkshire sold these puts, they received $4.2 billion as premiums for their risk when they sold these during the years from 2004 to 2008. Guarantor of the options and Berkshire Hathaway founder Warren Buffet has cheerfully invested these billions in premiums and made considerable returns on them since those years in which they sold them.
Another classic example surrounds PepsiCo. The California-based company always reports its earnings in U.S. dollars. Yet it has operations all over the world because of its diversified soft drinks, bottled water, chips and snacks, alternative energy drinks like PowerAde, and juices divisions. This means that it must borrow, invest, and earn money in a range of currencies on every continent. The company has utilized currency swap agreements to help reduce the volatility of changing currency exchange rates on its costs to borrow and earn money in other currencies. The underlying assets would be Euros, British pounds sterling, Canadian dollars, Australian dollars, Japanese yen, Swiss francs, and other major world currencies.
In the end, there are literally trillions worth of derivatives which derive their actual value from an underlying asset of one type or another. This might be interest rates determined in London (the now-infamous LIBOR), stock market index values, or oil and gold hard commodities. Such derivatives make it possible for investors to engage with another party in a zero sum game where the stakes depend on the rises and fails of most any asset or market in the world. Neither party has to be directly involved in the underlying market or asset, thanks to these financial weapons of mass destruction called derivatives.