What it means
Derivatives, meaning contracts whose value is derived from something else, always point at an underlying. That underlying can be physical, such as barrels of oil or tonnes of wheat, or purely financial, such as an interest rate or a stock market index.
The contract holder rarely wants the item itself; they want exposure to the way its price moves. For most operating businesses the underlying is something they already buy or sell, which is exactly why hedging works.
A bakery that purchases wheat every month can take a position in wheat futures so that a rise in the price of the underlying is offset by a gain on the contract. The size of a derivative position is described by its notional amount, which is the quantity of the underlying it references multiplied by the price.
That figure can be far larger than the cash the business actually puts up, which is why derivatives magnify both gains and losses. Accounting rules require derivatives to be measured at fair value, so a reported gain or loss appears every period as the underlying moves.
Hedge accounting can smooth that volatility, but only where the business documents the link between the contract and the exposure it is meant to cover. Not every derivative settles by delivering the underlying, and most are cash settled, meaning the two parties simply pay each other the difference in value.
Employee share options, convertible loan notes and weather linked contracts all have underlyings too, so the idea reaches well beyond trading desks.
In practice
Real-world examples.
Example
An airline hedges jet fuel using contracts whose underlying is crude oil rather than the refined fuel it actually buys. The two prices usually move together but not perfectly, and the airline accepts that small mismatch, known as basis risk, in exchange for a liquid market.
Example
An employee at a listed retailer holds share options with a strike price of $18. The underlying is the company's ordinary shares, so when they trade at $25 each option carries at least $25 - $18 = $7 of intrinsic value.
Example
A property fund buys an interest rate swap to fix the cost of a floating rate loan. Here the underlying is a benchmark interest rate, so no physical asset ever changes hands and only cash reflecting rate movements passes between the parties.
Think of it
“Underlying asset is what the derivative is based on-the thing underneath the contract.
Formula
Calculation
Notional value of a position = quantity of the underlying x price of the underlying
Gain or loss on the position = quantity x (new price of the underlying - original price)
A coffee roaster expects to buy 100,000 pounds of green coffee in six months and locks in a futures price of $2.40 per pound. The notional value of the position is 100,000 x $2.40 = $240,000, and the underlying asset is the coffee itself.
Six months later the spot price has risen to $2.70 per pound. The physical purchase now costs 100,000 x $2.70 = $270,000, which is $30,000 more than budgeted.
The futures position gains 100,000 x ($2.70 - $2.40) = $30,000, so the effective cost lands back at $270,000 - $30,000 = $240,000. Had the price fallen to $2.10 instead, the physical coffee would have cost $210,000 but the contract would have lost $30,000, giving the same $240,000 outcome, which is the point of a hedge.Case study
Seen in the real world.
What follows is an illustrative and entirely fictional case. Tallow Bay Foods, an invented ready meal producer, bought a large volume of chicken every quarter and had watched its margin swing wildly for two years as poultry prices moved. Its board approved a hedging policy without asking a basic question about the underlying.
The treasurer bought contracts on a broad agricultural commodity index because it was cheap and easy to trade. When poultry prices spiked the following winter, the index barely moved, since it was dominated by grains, and Tallow Bay took the full cost increase on the chin while also paying for a hedge that had done nothing.
The fictional post mortem was blunt. A hedge is only as good as the match between its underlying and the exposure it is meant to cover, and a loosely correlated underlying is closer to a speculative position than to protection.
Watch out
Common mistakes.
- Assuming that buying a derivative means you will end up owning the underlying, when the large majority of contracts are settled in cash and never involve delivery.
- Hedging with an underlying that only loosely tracks the real exposure, which leaves a gap that can be as costly as having no hedge at all.
- Judging the risk of a position by the cash paid for it rather than by the notional value of the underlying it controls.
Questions
People also ask.
Can an underlying asset be something you cannot physically hold?
Yes, and interest rates, share indices, exchange rates and even measured rainfall are all used as underlyings in traded contracts.
Why does the underlying matter for the accounts?
Because the derivative must be revalued as the underlying moves, and those movements flow through profit or reserves depending on whether hedge accounting applies.
Does a business need to own the underlying to use a derivative on it?
No, which is precisely the difference between hedging an exposure you genuinely have and speculating on one you do not.
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