Understanding the Difference Between Underlying Assets vs Derivatives

In the complex world of finance, the terms underlying assets and derivatives are frequently used but often misunderstood. Grasping the distinctions between these two concepts is essential for anyone looking to navigate the financial markets effectively. This article breaks down these terms, explores their unique characteristics across various asset classes, examines the global volumes traded, and discusses how speculation can impact underlying assets. Additionally, it provides definitions in layman’s terms to clarify complex financial jargon.

Defining Underlying Assets and Derivatives

An underlying asset is a tangible or financial asset upon which a derivative’s price is based. Examples include stocks, bonds, commodities like gold or oil, currency pairs in forex, or market indices. These assets have intrinsic value and can be traded directly in financial markets.

Derivatives are financial instruments whose value is derived from the price of an underlying asset. They include futures, options, swaps, and CFDs (Contracts for Difference). Derivatives do not grant ownership of the underlying asset but allow traders to speculate on price movements or hedge against potential risks. For instance, speculation involves trading to profit from anticipated price changes, while hedging is a strategy to protect against financial losses. (Refer to “Definitions in Layman’s Terms” at the end for more details.)

Unique Characteristics Across Asset Classes

Over the years, analysts have identified specific nuances in how underlying assets and derivatives function within different asset classes. Understanding these distinctions can enhance investment strategies and risk management.

1. Stocks

• Underlying Assets: Stocks represent direct ownership in a company, entitling shareholders to dividends and voting rights. Their value is influenced by the company’s performance, industry trends, and overall market sentiment.
• Derivatives: Stock options and futures allow investors to speculate on price movements or hedge positions. Options grant the right, but not the obligation, to buy or sell a stock at a predetermined price. This provides flexibility and leverage—using borrowed funds to amplify potential returns—without the need to invest the full amount required to own the stock outright.

2. Exchange-Traded Funds (ETFs)

• Underlying Assets: ETFs are investment funds that track indexes, sectors, commodities, or assets. They offer diversification by holding a basket of securities.
• Derivatives: ETF options and futures enable traders to speculate on the performance of the entire fund or hedge their portfolios. Leveraged ETFs magnify exposure to the underlying index or asset, which can lead to higher returns or losses.

3. Forex (Foreign Exchange)

• Underlying Assets: Forex involves trading currency pairs, such as EUR/USD, where investors buy one currency while selling another. Exchange rates are influenced by economic indicators, interest rates, and geopolitical events.
• Derivatives: Forex derivatives like futures and options allow traders to speculate on currency movements with greater leverage. This means small changes in exchange rates can result in significant profits or losses. Due to high liquidity and 24-hour market access, forex derivatives are popular among speculators.

4. Commodities

• Underlying Assets: Physical commodities include goods like gold, oil, natural gas, and agricultural products. Their prices are affected by supply and demand, weather conditions, and global economic health.
• Derivatives: Commodity futures and options enable producers and consumers to hedge against price volatility. For example, a farmer might use futures contracts to lock in a selling price for their crop. Speculators also trade these derivatives to profit from expected price movements, adding liquidity to the market.

5. Indices

• Underlying Assets: Market indices, such as the FTSE 100 or S&P 500, represent the performance of a group of stocks but are not directly investable.
• Derivatives: Index futures and options allow traders to speculate on the overall market direction or hedge against portfolio risks. These derivatives are essential tools for institutional investors managing large-scale exposures.

Note: Definitions of terms like “hedging,” “speculation,” “options,” and “leverage” are provided in layman’s terms at the end of this article.

Global Volumes: Underlying Assets vs Derivatives

The scale of trading in derivatives often surpasses that of underlying assets, varying significantly across asset classes. This reflects the speculative interest and hedging needs in financial markets.

• Forex: The global forex market sees over $6 trillion traded daily. However, the notional value of forex derivatives exceeds spot forex trading. The Bank for International Settlements reports that derivatives account for a significant portion of forex market turnover, highlighting the prominence of speculative and hedging activities over actual currency exchange for trade.
• Commodities: In commodities markets, the volume of derivatives trading can be multiple times larger than the physical market. For example, in gold trading, it’s estimated that for every physical ounce of gold, there are numerous derivative contracts representing claims on that ounce. This disparity underscores the speculative nature of commodity derivatives.
• Equities: While stock markets have substantial trading volumes, the derivatives market for equities, including options and futures, adds an additional layer. Investors and institutions use these derivatives for hedging and speculative purposes, often leveraging positions to amplify potential returns.
• Interest Rate and Credit Derivatives: These are some of the largest segments of the derivatives market by notional value. Institutions use them extensively to manage exposure to interest rate changes and credit risk, reflecting the importance of derivatives in financial risk management.

The significant volumes in derivatives compared to underlying assets illustrate the financial market’s reliance on these instruments for speculation and risk management. Asset classes like forex and commodities exhibit the largest gaps, with derivatives trading far exceeding physical transactions.

Impact of Speculation on Underlying Assets

Speculation in derivatives markets can influence the prices of underlying assets, sometimes leading to significant market movements. Understanding this relationship is crucial for investors to assess potential risks and opportunities.

Influence Mechanisms

• Price Discovery: Derivatives markets contribute to setting prices for underlying assets. Heavy trading in derivatives can signal market expectations, affecting spot prices.
• Market Sentiment: High levels of speculative activity can sway investor perceptions, leading to increased volatility in underlying asset prices.
• Liquidity Effects: Derivatives trading adds liquidity to the markets, but excessive speculation can lead to imbalances.

Historical Examples

• 2008 Oil Price Surge: In 2008, oil prices soared to over $140 per barrel. Analysts suggest that excessive speculation in oil futures significantly contributed to this spike. The influx of speculative capital drove futures prices higher, which, through arbitrage and market expectations, pushed up spot prices. This had widespread economic impacts, increasing fuel costs globally.
• 2010 Flash Crash: On May 6, 2010, U.S. stock markets experienced a rapid and severe downturn, with the Dow Jones Industrial Average dropping nearly 1,000 points within minutes. Investigations pointed to algorithmic trading and high-frequency trading in stock index futures as key factors. The speculative activities in derivatives markets triggered sell-offs in the underlying stocks, causing a temporary market collapse.
• Gold Price Manipulation Allegations: There have been instances where heavy trading in gold derivatives led to suspicions of price manipulation. Large speculative positions in gold futures were thought to influence the spot price of gold, affecting investors holding the physical asset.

Risk Indicators

• Open Interest: The total number of outstanding derivative contracts. A high open interest can indicate strong speculative activity.
• Trading Volume: Sudden increases in trading volume can signal heightened speculation, potentially leading to increased volatility.
• Volatility Indexes: Measures like the VIX (Volatility Index) reflect market expectations of volatility, often influenced by derivatives trading.

Understanding these factors can help investors assess the potential impact of speculation on their investments in underlying assets.

What Do Brokers Offer?

Brokers provide access to a variety of financial instruments, including underlying assets and derivatives. The offerings can vary significantly between brokers and asset classes.

The following table shows the different asset classes available through various brokers and their accessibility for both underlying assets and derivatives:

Sources: Broker websites and public disclosures.
Disclaimers: 1) Offerings are subject to change. Verify directly with brokers for the most current information. 2)It’s important to understand that while some brokers offer direct access to underlying assets, others provide trading through derivatives like CFDs or futures. CFDs, or Contracts for Difference, are derivative products that allow traders to speculate on price movements without owning the underlying asset. This can involve higher risk due to leverage.

Legend:

✔️ = Available: Indicates the broker offers the specified financial instrument.
❌ = Not Available: Indicates the broker does not offer the specified financial instrument.
ℹ️ = Not Applicable (due to nature of asset): Indicates the broker cannot offer the underlying for indices because indices are benchmarks and cannot be owned directly.

Conclusion

Understanding the distinctions between underlying assets and derivatives is crucial for effective participation in financial markets. While underlying assets represent direct investment and ownership, derivatives offer opportunities for speculation, hedging, and leveraging positions. Each asset class presents unique characteristics and risks, making it essential to align investment strategies with individual goals and risk tolerance.

As financial markets continue to evolve, staying informed about the instruments available and the potential impacts of market activities is vital. Engaging with reputable brokers and conducting thorough research can help navigate the complexities of trading and investing.

Definitions of Interest

• Hedging: A strategy used to reduce or eliminate financial risk. Think of it as buying insurance for your investments to protect against adverse price movements.
• Speculation: The act of trading assets or derivatives to profit from anticipated changes in market prices. Speculators aim to buy low and sell high, often taking on significant risk.
• Options: Financial contracts that give the buyer the right, but not the obligation, to buy or sell an asset at a specific price within a set time frame. This flexibility allows for strategic investment decisions.
• Leverage: Using borrowed funds or financial instruments to increase the potential return on an investment. While it can amplify profits, it also increases the risk of significant losses.
• Open Interest: The total number of active contracts in the derivatives market that have not been settled. High open interest can indicate increased market activity and potential volatility.
• CFDs (Contracts for Difference): A type of derivative that allows traders to speculate on price movements of underlying assets without owning them. Profits or losses are calculated based on the difference in the asset’s price from when the contract is opened to when it is closed.
• Futures: Financial contracts obligating the buyer to purchase, or the seller to sell, an asset at a predetermined future date and price. Futures are standardized and traded on exchanges.

Disclaimer: the content provided in this article is for informational purposes only and should not be considered financial advice. BrokerSuperMarket does not guarantee any specific financial outcomes or investment results. Always conduct your own research and consult with a qualified professional before making investment decisions.