Underlying markets refer to the specific financial market where the asset, upon which a derivative is based, is actively traded.

This asset, known as the underlying asset, can include a broad range of instruments such as stocks, bonds, commodities, currencies, indices, and even cryptocurrencies.

The price movements, liquidity, and overall behaviour of assets within the underlying market have a direct influence on the valuation and risk profile of the associated derivative instruments.

Underlying Markets and Their Role in Derivative Trading

Derivatives are financial contracts that derive their value from the performance of an underlying asset. These instruments include:

• Options (stock options, commodity options, currency options)
• Futures contracts (stock index futures, oil futures, gold futures)
• Swaps (interest rate swaps, currency swaps)
• Forwards (foreign exchange forwards, commodity forwards)

The underlying market is the actual marketplace where these assets are traded, and its fluctuations directly impact derivative pricing, risk assessment, and trading strategies.

Market participants traders, institutional investors, hedge funds, and speculators closely monitor underlying market trends to make informed decisions about their derivative positions.

Types of Underlying Markets and Their Characteristics

The concept of underlying markets applies to different asset classes, each with its unique characteristics, trading venues, and market dynamics.

1. Equities (Stocks) as an Underlying Market

In the case of stock options, the underlying market refers to the stock exchange where the company’s shares are actively traded. The price movements of these stocks influence the pricing and profitability of derivative contracts.

Example

A trader purchases a call option on Apple Inc. (AAPL). If Apple’s stock price rises, the value of the option increases.

If the stock price declines, the call option loses value. The New York Stock Exchange (NYSE) and Nasdaq serve as key underlying markets for such derivatives.

2. Commodities as an Underlying Market

For commodity futures and options, the underlying market consists of physical and futures exchanges where raw materials such as gold, crude oil, wheat, natural gas, and silver are traded.

Example

A futures contract on crude oil derives its value from the actual oil market, where prices are determined based on global supply-demand dynamics, geopolitical factors, and economic indicators.

The Chicago Mercantile Exchange (CME) and Intercontinental Exchange (ICE) are major platforms where commodity derivatives are traded.

3. Currencies (Foreign Exchange) as an Underlying Market

Currency derivatives, such as forex futures, options, and swaps, are based on the exchange rates of currency pairs (e.g., EUR/USD, GBP/JPY).

The foreign exchange (forex) market is the world’s largest and most liquid financial market, influencing the valuation of forex-related derivatives.

Example

A trader holding a EUR/USD futures contract is exposed to fluctuations in the Euro against the US Dollar.

The underlying market, in this case, is the global forex market, which operates 24/5 with major trading centres in London, New York, Tokyo, and Sydney.

4. Indices as an Underlying Market

Stock index derivatives, such as S&P 500 futures, Nasdaq 100 options, and Dow Jones swaps, derive their value from benchmark indices that track multiple stocks.

Example

A trader purchasing an S&P 500 futures contract is essentially betting on the performance of the S&P 500 index, which is composed of 500 major US companies. Changes in these companies’ stock prices affect the futures contract’s value.

The Chicago Board Options Exchange (CBOE) and CME Group facilitate trading in these index-based derivatives.

5. Bonds as an Underlying Market

For bond derivatives, such as interest rate swaps and bond futures, the underlying market consists of government and corporate bonds issued by governments or corporations.

Example

A 10-year US Treasury Note futures contract derives its value from the prevailing interest rates and Treasury bond market conditions. The US Treasury market and platforms like CBOT (Chicago Board of Trade) serve as the underlying markets for bond derivatives.

6. Cryptocurrencies as an Emerging Underlying Market

Cryptocurrencies, such as Bitcoin (BTC), Ethereum (ETH), and Ripple (XRP), have become new underlying assets for derivatives like crypto futures and options.

Example

A Bitcoin futures contract traded on the Chicago Mercantile Exchange (CME) derives its value from Bitcoin’s price movements in the underlying crypto market.

How Underlying Markets Influence Derivative Trading

The relationship between the underlying market and derivative instruments is crucial for traders and investors. Several factors affect the pricing and valuation of derivatives:

1. Price Volatility

High volatility in the underlying market increases the premium for options and the risk exposure for futures contracts.

Traders use volatility indicators like Implied Volatility (IV) and the VIX (Volatility Index) to gauge market sentiment.

2. Liquidity and Market Depth

A highly liquid underlying market ensures the smooth execution of derivative trades with minimal slippage.

Illiquid markets, on the other hand, result in wider bid-ask spreads and increased trading costs.

3. Macroeconomic Factors

Interest rates, inflation, central bank policies, and geopolitical events impact currencies, stocks, and commodities, influencing the value of derivatives tied to these markets.

4. Market Sentiment and Speculation

Hedgers (e.g., institutional investors) use derivatives to reduce exposure to price fluctuations in the underlying market.

Speculators trade derivatives based on expected price movements, often amplifying volatility in the underlying market.

Role and Significance of Underlying Markets

The underlying market plays a pivotal role in the valuation and risk assessment of derivatives. Key aspects include:

1. Price Determination

The current price of the underlying asset in its market serves as the foundation for the derivative’s value. Fluctuations in this market directly impact the derivative’s pricing.

2. Risk Management

 Understanding the underlying market allows traders and investors to hedge positions effectively, mitigating potential losses from adverse price movements.

3. Market Liquidity

The liquidity of the underlying market affects the ease with which derivatives can be traded. Highly liquid underlying markets typically lead to more liquid and competitively priced derivatives.

Examples of Underlying Markets

1. Stock Options

 Consider an investor holding a call option for Company XYZ’s stock. The underlying market here is the stock exchange where Company XYZ’s shares are traded. If the stock’s price rises, the value of the call option generally increases.

2. Commodity Futures

 A trader enters into a futures contract for crude oil. The underlying market is the global oil market, and changes in oil prices will affect the futures contract’s value.

3. Currency Swaps

A corporation engages in a currency swap to manage exposure to foreign exchange fluctuations. The underlying market involves the forex markets where the relevant currency pairs are traded.

Conclusion

Underlying markets are continually evolving, influenced by economic shifts, technological advancements, and regulatory changes. 

For example, the emergence of cryptocurrencies has introduced new underlying markets, leading to the creation of crypto-based derivatives. 

Additionally, environmental considerations are giving rise to derivatives based on carbon credits and other sustainability metrics.