Underlying Assets
The price of a financial instrument called derivative is based on the price of another asset. These assets which help decide the price of a financial security are called underlying assets. The underlying assets can be any of the financial security or instrument like currency, stocks, indexes, commodity, bonds etc. The derivatives can be any of the following like futures, options, forwards and swaps.
Why Option is called a Derivative?
Consider a stock option. When a stock option is traded, we do not trade the underlying asset –stock, but buy or sell the “right” to buy and sell. The value of this “right” to buy or sell depends on the price of the stock. Hence, in this case the stock is the underlying asset for the option. The price of the option/ right is “derived” from the price of the stock. Hence the option is called a derivative.
Derivatives used for Bet
The underlying assets are not owned by the investors in derivatives. The investor only makes a bet on the direction of price movement of this underlying asset on the basis of an agreement with counter party. A small movement in the price of underlying results a large movement in the price of these derivatives and hence the returns on the derivatives can be high. However, with the possibility of increased returns, the risk is also high. The derivatives can result in large losses in case the value of the underlying asset moves in a direction opposite to that of the anticipated direction. Hence, one must be very careful while dealing with these securities.
Consider the case of the financial crisis in 2007-08. A lot of people & banks anticipated that the real estate prices will increase and had bought derivatives that bet on the movement of underlying asset -real estate prices moving upwards. However, in 2008, the price of real estate started declining resulting in heavy losses for holders of the derivatives.
