Understanding Underlying Assets in Derivatives: Meaning, Types & Role

Underlying Asset Meaning

In financial derivatives, an underlying asset refers to the financial instrument upon which a derivative contract is based. The value of the derivative is directly linked to the price movements of this asset. In the Indian context, underlying assets can include equities, indices (like Nifty 50 or Bank Nifty), currencies (like USD/INR), government securities (G-Secs), and even commodities traded on exchanges like MCX.

While derivatives are merely contracts, the underlying asset lends them intrinsic relevance. For instance, an Nifty 50 futures contract derives its value from the Nifty 50 index. Thus, understanding the behaviour, liquidity, and volatility of the underlying becomes a prerequisite for effective trading and risk management.

Types of Underlying Assets

In India, the derivative market is well-regulated by SEBI and operates across multiple asset classes. The major types of underlying assets in derivatives include:

1. Equity
This includes individual stocks such as Reliance Industries, HDFC Bank, or Infosys. NSE offers futures and options (F&O) on more than 180 liquid equity stocks.

2. Equity Indices
Contracts based on indices like Nifty 50, Bank Nifty, and Nifty Financial Services are among the most traded derivatives in India due to high liquidity and lower margin requirements.

3. Currency Pairs
The Indian market allows trading in currency derivatives involving USD/INR, EUR/INR, GBP/INR, and JPY/INR pairs. The underlying here is the exchange rate between the two currencies.

4. Interest Rate Instruments
RBI-regulated bonds such as 6.45% G-Sec 2029 or Treasury Bills are used as underlying assets for interest rate futures on the NSE.

5. Commodities
Under MCX and NCDEX, commodities such as crude oil, gold, silver, copper, and agri-products serve as underlying assets for commodity futures and options.

Importance of Underlying Assets in Financial Markets

The underlying financial asset plays a vital role in ensuring price discovery, contract settlement, and risk transfer in the derivatives market.

Price Determination: The value of a derivative is derived from the underlying asset’s spot price. Any change in the price of the underlying instantly impacts the derivative contract.

Liquidity and Volatility: Liquid and volatile underlying assets (e.g., Nifty 50 or Reliance) ensure tighter spreads and active trading, thereby improving market efficiency.

Risk Management: Institutional investors, FIIs, and mutual funds hedge their portfolios using derivatives based on underlying assets to neutralise market risk.

Regulatory Oversight: SEBI mandates strict listing criteria and margin norms for underlying assets to be eligible for derivative trading, ensuring transparency and systemic safety.

Examples of Underlying Assets

To better understand the dynamics, here are a few real-world underlying assets examples from the Indian market:

These underlying investments are chosen for their liquidity, market depth, and standardised price discovery.

What is the Relationship Between the Underlying Asset in Derivatives

The relationship between a derivative and its underlying asset is one of dependence and reactivity. The derivative does not have value in isolation; its value, profitability, and payoff structure are entirely determined by the price movement of the underlying.

1. In Options: The intrinsic value is the difference between the strike price and the underlying’s spot price.
2. In Futures: The profit or loss depends on how the underlying price moves after entering the contract.
3. In Hedging: A short position in futures can hedge a long position in the underlying stock.

The market anticipates this relationship through metrics like delta, gamma, and implied volatility, particularly in the Indian options market.
 

Conclusion

The underlying asset in a derivative is not just a reference point; it is the foundation of the contract’s value, relevance, and strategy. In the Indian financial ecosystem, understanding the behaviour, volatility, and regulatory framework of these assets is essential for both retail and institutional participants. Whether you're trading Bank Nifty weekly options or using interest rate futures to hedge bond portfolio risk, the underlying determines everything from margin requirements to profit potential.