Understanding Derivatives and Their Foundation: What Makes an Example of Underlying Asset Work?

The Basics: What Powers Derivatives?

Financial derivatives often puzzle newcomers to trading, but here’s a simple way to think about them: they’re essentially agreements whose value hinges on something else. That “something else” is called the underlying asset, and it’s the engine that drives the entire derivative market. Without understanding what makes an example of underlying asset valuable, you can’t truly grasp how options, futures, and other derivative instruments function.

A derivative gets its value from fluctuations in its underlying asset. When the underlying asset moves, the derivative moves with it. This relationship is what makes derivatives powerful tools for traders and institutions alike—but also what makes them risky if you don’t know what you’re doing.

What Exactly Are Derivatives and Underlying Assets?

In the financial world, a derivative is a contract whose price is determined by something else’s value. That something is the underlying asset. Think of it this way: the underlying asset is the anchor, and the derivative is the boat tied to it. When the anchor moves, the boat follows.

Derivatives serve multiple purposes in modern finance. Traders use them for speculation—essentially betting on future price movements. Institutions use them for hedging, which is a fancy way of saying “insurance against bad outcomes.” And markets use them for price discovery, which helps establish fair market values. However, these instruments come with their own complications: they involve leverage, they’re complex to value, and they can expose you to counterparty and systemic risks.

The three most common types of derivatives you’ll encounter are options, futures, and swaps.

Major Classes of Underlying Assets Explained

Here’s what’s fascinating about the derivatives market: almost anything tradeable can become an underlying asset. The rise of cryptocurrency has only expanded this universe. Let’s walk through the major categories:

Equities and Corporate Shares

Stock options and equity futures are among the oldest and most traded derivatives. When you buy a call option on Apple shares, for example, you’re holding a derivative whose value depends on Apple’s stock price. This example of underlying asset behavior is foundational to options trading.

Fixed Income: Bonds

Governments and corporations issue bonds, and these have become popular underlying assets for bond options, interest rate swaps, and bond futures. An institution worried about rising interest rates might use bond futures to protect their portfolio.

Currencies and Stablecoins

Currency derivatives let traders speculate on exchange rates or hedge against forex fluctuations. In the decentralized finance space, stablecoins like USDC are pegged to fiat currencies and serve as digital examples of underlying asset relationships—the stablecoin’s value is anchored to dollars held in reserve.

Cryptocurrencies: The Modern Frontier

Bitcoin, Ethereum, and other digital assets have become increasingly important underlying assets for derivatives. Crypto options and futures now represent a massive segment of the derivatives market. Bitcoin futures, in particular, allow both retail and institutional traders to gain exposure to price movements without holding the actual coins.

Market Indices

An index tracks a basket of securities. A stock market index like the S&P 500 can itself be an underlying asset for index futures and index options. When the aggregate value of the underlying companies rises, so does the index—and any derivatives based on that index.

Real-World and Tangible Assets

Through NFTs and tokenization, real-world assets like artwork and real estate can now serve as underlying assets for digital derivatives. This example of underlying asset innovation shows how blockchain technology is expanding the derivatives market beyond traditional finance.

Exchange-Traded Funds (ETFs)

ETFs, being publicly traded funds, can also function as underlying assets for ETF options and index futures.

How Options Work: A Practical Example

Let’s say you hold Bitcoin and you’re generally optimistic about its future, but you’re concerned about a potential crash in the next three months. Here’s where options come in handy.

You could purchase a three-month put option contract with the following terms:

• Premium paid: $500
• Right to sell: 10 BTC
• Strike price: $35,000 per coin
• Current market price: ~$40,000
• Discount to current price: 12.5%

If Bitcoin tumbles below $35,000 before the expiration date, you can exercise your right to sell at $35,000, effectively locking in that price and offsetting your holdings’ losses. If Bitcoin stays above $35,000, you simply let the option expire—your maximum loss is the $500 premium. This is a textbook example of underlying asset leverage working in your favor.

Futures Contracts: Obligations, Not Choices

Unlike options, futures contracts create an obligation. Both the buyer and seller must complete the transaction at the predetermined price on the settlement date. There’s no premium to pay upfront; instead, you typically post margin.

A farmer illustrates this perfectly: they might lock in a minimum sales price for their harvest using agricultural futures, hedging against price drops. The same principle applies to crypto—a holder might use Bitcoin futures to lock in a selling price at a specific future date.

What Doesn’t Work as an Underlying Asset?

Not every asset qualifies. For a derivative to function properly, its underlying asset must be tradeable with price discovery possible. Personal property doesn’t work because you can’t efficiently trade it. Patents and brands, while valuable, lack liquid markets. Perishable goods and items that are expensive to store also fall short.

The key requirement: there must be a functioning marketplace where the asset can be bought and sold, establishing clear price signals.

A Fun Fact: Weather Derivatives

One of the most creative—and unusual—examples of underlying asset usage emerged in the late 1990s: weather derivatives. These contracts use temperature, rainfall, and other meteorological indices as their underlying assets.

Why? Industries like agriculture, energy, and tourism have revenues directly tied to weather conditions. A harsh winter or drought can devastate earnings. Weather derivatives let these businesses hedge against unfavorable conditions, turning an unpredictable natural phenomenon into a manageable financial risk.

The Bottom Line

Understanding what an example of underlying asset looks like is your first step toward mastering derivatives. Whether it’s cryptocurrency, traditional stocks, currencies, or even the weather, the underlying asset is the foundation. When you grasp how underlying assets move and how derivatives derive their value from that movement, you’re equipped to make more informed trading decisions.

The derivatives market continues to evolve, especially with the rise of digital assets. As more assets become tokenized and tradeable, expect the list of possible underlying assets to grow—creating new opportunities and risks for traders to navigate.