In finance, an underlying asset is the asset that determines a derivative's value.
Take, for example, a call option on a stock. A call option gives you the right to buy or sell a stock at a specific price at some time in the future.
The value of any stock option depends on the value of the underlying stock. For example, if you have a $25 call option on a stock that currently trades for $30 per share, your option should be worth at least $5. The option gives you the right to buy the stock for $25, even though the current market price for the stock is $30, thus the value of the option is $5.
In this case, the underlying asset is the stock, because the price of the stock is what gives the option its value.
Similarly, a put option gives you the right to sell a stock at a known price and date in the future. The value of the put option also depends on the value of the underlying stock. If you own a put option to sell a stock for $20 per share, and the stock currently trades for $10 per share, the value of the option should be at least $10. The option derives its value from the value of the underlying asset -- hence the term "derivative."
Underlying assets in real-world examples
Warren Buffett famously called derivatives "financial weapons of mass destruction" -- yet his company, Berkshire Hathaway (NYSE:BRK-A)(NYSE:BRK-B), will happily sell them at the right price. Berkshire Hathaway has sold a number of put options on various stock market indexes, from the S&P 500 to the FTSE 100. Notably, the put options will not expire until sometime between January 2018 and January 2026, at which point the value of the underlying assets (the indexes) will determine how much Berkshire must pay out.
In the extraordinarily unlikely event that the underlying assets -- the indexes -- go to zero, Berkshire would have to pay out as much as $27.6 billion to the put buyers. Berkshire Hathaway received $4.2 billion up front from 2004 to 2008 to compensate for the risk it was taking on, which Buffett has happily invested and earned a return on ever since.
Coca-Cola (NYSE:KO) reports earnings in dollars, but it borrows in currencies all around the world. Until April 2015, Coca-Cola used swaps to minimize the impact of fluctuating exchange rates on its borrowing costs. In its 2014 annual report, the company owned swaps worth $2.6 billion, of which the underlying asset was the euro. These swaps protected Coca-Cola from ever-changing currency prices, as the company reports its earnings in dollars.
Trillions of dollars in derivatives ultimately get their value from some underlying asset, whether it's the current trading level of a stock market index, interest rates in London, or the market value of eggs and orange juice. From speculators to Fortune 500 companies, derivatives enable a buyer to win or lose based on the ups and downs of practically any market, all without directly participating in the market for the underlying asset.
If you really wanted to, you could wager on gasoline prices by storing thousands of gallons of gas in your backyard. But why go through the trouble when gasoline futures allow you to profit from (or lose money on) gas prices without having to store, and later sell, massive amounts of a flammable liquid?
Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway and Coca-Cola. The Motley Fool owns shares of Berkshire Hathaway and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.