What is underlying and how it differs from contracts?

Last Updated: 27 Jul 2022

One of the most common terms you get to a year in the derivatives market is the term “Underlying Asset”. What is an underlying asset and how does it link to the F&O contract? To understand what is an underlying asset, we need to first know that futures and options are derivative products as their value is derived from another asset. If that asset value goes up, the value of this derivative also moves up or down, depending on what is this derivative we are talking about. That asset is called the underlying asset. So, the very Underlying Asset meaning is that it is the asset that defines the value of the derived contract.

What is an underlying and how is it different than a contract?

If you have by now understood the Underlying Asset meaning, you would know that the contract and the underlying are the two sides of the same coin. For example, the underlying is the asset on which the derivative contract is built. The derivative contract derives its value from this underlying asset. Let us quickly sum it up.

• An underlying is normally an asset like an equity or a commodity or a bond but it can also be a national asset like the nifty index or foreign currency exchange rates etc.
• Underlying is the source of value for the derivative contract. On the other hand, the derivative contract derives its value from the Underlying Asset.
• Derivatives are contracts and hence remain in your trading account and would not find a place in your Demat account as they are not strictly assets that can be owned. Underlying can normally be owned, either directly or through proxies; like index ETFs.

Underlying and contract with a live example

Let us take a live example of an Infosys contract to understand this distinction between underlying and contracts.

Data Source: NSE

If you look at the above snapshot of Infosys futures, here are some important inferences you can draw about underlying versus contracts.

• In the above case, the contract is the futures contract expiring on the last Thursday of June i.e., 24 June. On that day this futures contract will cease to exist.
• The Infosys futures contract is a derivative contract that derives its value from the underlying Infosys stock. Therefore, Infosys stock becomes underlying in this case.
• The price of the contract is different from the price of the underlying. For example, the Infosys June futures are priced at Rs.1508.45 but the underlying Infosys stock is priced at Rs.1,510 as you can see the price shaded in yellow.
• On the date of expiry, the price of the Infosys futures and the spot price of Infosys will converge at the same level. That is the 24 of June when the current F&O contract will expire.
• The order book that you get to see in the snapshot above pertains to the bid and ask prices of the Infosys futures contract and not the underlying Infosys stock.

That, surely, clarifies the essential difference between a derivatives contract and the underlying asset.

What is meant by calendar spread?

A calendar spread can be created using options or using futures, although futures are more common. This strategy is executed by simultaneously entering into a long position and an offsetting short position on the same underlying asset but with different maturity/expiry dates. For example, buying Nifty June and selling Nifty July futures or buying RIL June and selling RIL August. Both are instances of calendar spreads.

In a typical calendar spread, one would buy a longer-term contract and go short a nearer-term option with the same strike price, however, there is no such hard and fast rule. The normal rule is to buy the under-priced contract and sell the overpriced contract so that you gain from the spread narrowing. You are broadly indifferent to the price levels of the Nifty.

Calendar spreads are popularly referred to as horizontal spreads as they are across the same contract class across different maturities. This has to be understood distinctly from the popular F&O strategies like bull call spread and bear put spread which is two different strike prices for the same month and these are popularly referred to as diagonal spreads.

How long does a future contract last?

A future is a contract that will last till its expiry. On the day of expiry at the close of trade, the futures contract ceases to exist and is fully closed out and appropriate profits/losses are credited or debited to the respective holders of the contracts. For example, in stock futures in India, the contracts normally expire on the last Thursday of the month. That is the day the contract expires. On the day of expiry, the current monthly contract becomes worthless and a new far month contract is introduced by the stock exchange.

Frequently Asked Questions

Can Currency be an underlying asset?

Of course, currencies are one of the most popular underlying asset classes in futures and options market. In the Indian market, the underlying in the currency contract future is the currency spread. For example, USDINR futures at Rs.73.50 is a contract where USDINR is the underlying. If you expect dollar to strengthen, you buy the contract and if you expect the dollar to weaken you sell this contract.

How is the underlying asset valued?

The underlying asset is valued on its intrinsic value. Equities are valued on cash flows and bonds are valued on interest rate yield movements.

What is the use of the underlying assets?

The underlying asset serves as the benchmark for the pricing of the futures and options contract.