CFM13030 - Understanding corporate finance: derivatives: the underlying

Main types of underlying

The majority of derivative products based on deliverable assets are related to one of the following underlying matters.

· Interest rates. A very common use of derivatives by companies is to hedge interest rates - this is discussed in more detail at CFM13280. The interest rate itself may be the underlying, such that payments due under the derivative are calculated by reference to the application of a specified interest rate to a notional principal amount. Alternatively the relationship to the interest rate may be indirect. The amounts payable are related to the price of a very high credit quality security, such as a US treasury bond or the price of a notional security with defined interest rate linked characteristics. See CFM13020, first bullet point.

· Foreign exchange (see CFM13400) - for example, the underlying can be a specified amount of 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 derivatives listed above may or may not be capable of leading to delivery of the underlying, depending on the documentation. In other cases, the underlying may be something which is, of its nature, undeliverable. Common types of inherently 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.

In the tax definition of a derivative contract, an option or future are capable of leading to delivery of the underlying, but in practice may well be cash-settled. On the other hand, if the contract cannot lead to delivery, it is known as a contract for differences, see CFM50310+.

The derivatives industry continues to develop into new areas. 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), real property, bandwidth or pollution credits.