Underlying: what it is and why it is critical for financial derivatives

The term underlying refers to the variable or asset on which the price of a derivative instrument depends. In essence, the value of a derivative is closely related to the performance of its underlying asset, which can be represented by variables such as stocks, market indices, interest rates, currencies, commodities, and even weather. This correlation is what makes the underlying a key component in determining the value of any derivative. Any movement in the underlying directly or indirectly affects the price of the derivative, which is why choosing and understanding the nature of the underlying becomes essential for those operating in the financial markets.

Categories of underlyings: stocks, indexes, and beyond

Underlyings can be classified into various categories based on their nature. The main types include:

• Equity derivatives: these are based on the individual shares of listed companies.
• Index derivatives: the underlying is a market index, such as the FTSE MIB.
• Interest rate derivatives: these refer to specific rates such as LIBOR.
• Currency or exchange rate derivatives: the value depends on the exchange rate between currencies.
• Credit risk derivatives: protect against default risk.
• Commodity derivatives (commodities): linked to commodities such as oil or gold.
• Bond derivatives: are based on listed bonds.

Each of these underlyings allows derivatives to adapt to different hedging or speculation objectives, offering tools to manage the specific risks associated with movements in these reference variables.

Importance of the underlying for derivatives valuation

The underlying plays a key role in pricing a derivative and assessing its volatility, exposing investors to varying degrees of risk. The underlying variable can consist of different types of assets, such as stocks, indices, interest rates, currencies, commodities, or bonds, and each of these involves specific market dynamics that affect the stability of the derivative. For example, a derivative based on the stock of a technology startup tends to have high volatility, being more prone to rapid and unpredictable fluctuations than a derivative based on the stock of a large, established, stable company. Similarly, a derivative on a commodity such as oil will be affected by geopolitical and market variables that do not affect derivatives on different underlyings.

This difference in volatility and sensitivity between underlyings directly affects the risk associated with derivatives, and thus their attractiveness to different types of investors. Indeed, understanding the specific characteristics of the underlying asset helps investors select instruments that fit their investment and risk management strategies, better matching their risk profile and financial objectives.For those seeking greater stability, derivatives based on stocks of solid companies or bonds may be more appropriate, while investors with a high risk appetite may prefer derivatives on more volatile underlyings, such as startup stocks or commodities.

Weather derivatives: innovation in the world of derivatives

A particularly innovative category of underlyings is “weather derivatives,” or climate derivatives, whose value is affected by atmospheric variables such as temperature, precipitation, and other weather conditions. These financial instruments are useful for companies that want to protect themselves against adverse or unpredictable weather conditions, such as in agriculture and the energy industry. Weather derivatives make it possible to hedge climate-related risks and are an attractive diversification because weather conditions are independent of the performance of financial markets.

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