Understanding corporate finance: derivative contracts: underlying assets
Main types of underlying asset
The majority of derivative products based on deliverable assets are related to one of the following four underlying matters.
- Interest rates. The most common use of derivatives by companies is to hedge interest rates - this is discussed in more detail at CFM13280.
- An interest rate is simply a different way of expressing the price of a simple money debt. The underlying asset of contracts used to hedge, or speculate on, interest rate movements may be a real debt instrument such as a government or corporate bond, or a notional debt instrument or loan (CFM13020, first bullet point).
- Foreign exchange (see CFM13400). The underlying asset is foreign currency.
- Equities (see CFM13450). The underlying asset may be shares in a particular company, a basket of shares, or a share index such as the FTSE 100 or the Dow Jones Industrial Average. A share index is simply a way of measuring the price of a particular basket of shares.
- Commodities (see CFM13440). The most extensively traded commodity derivatives are based on crude oil and other oil products. Other forms of energy derivative are also available, for example natural gas and electricity derivatives, as well as derivatives based on precious metals, non-ferrous metals, and agricultural products such as wheat, sugar, coffee, cotton and so on.
The most common types of non-deliverable underlying subject-matter are credit and weather derivatives, both used for insurance-type purposes:
- Credit (see CFM13370). Companies that have lent money or extended credit to other businesses may feel that there is a risk of them defaulting. Therefore, they may use credit derivatives to protect themselves against this risk. In some cases, they may obtain credit protection by means of a derivative based on gilts, bonds or shares, but it is also possible to buy derivative contracts under which payments are made according to changes in the creditworthiness of a particular business, government or other borrower.
- Weather derivatives are more straightforward. Payments can be made according to movements in temperature or rainfall or any other readily measurable meteorological phenomenon.
The derivatives industry continues to develop into new areas. Occasionally you may meet derivatives where the underlying asset is outside the above categories - for example, insurance contracts (the derivative tracks the aggregate amount paid out under a particular class of insurance contracts), property, bandwidth or pollution credits.