An underlying asset is the financial asset that a derivative’s price is based on. Some examples of underlying assets are:
- interest rates
Underlying assets assign derivatives their value.
An Example of Underlying Assets
For example, an option gives the holder the right to buy (call) or sell (put) a financial asset. The contract will agree on a price called the strike price, as well as a date when this agreement will expire. If the strike price is $100 and the underlying assets price rises to $500 before the expiration date, the holder has the right to buy the asset at $100 and sell it at $500.
There are two main reasons derivatives are used: to hedge risk and speculation.
Hedging risk is using derivatives with the goal of minimizing risk in the market (supply and demand). For example, if an investor thinks an underlying asset’s price will fall, resulting in a loss of income, they may use derivatives to mitigate any losses. However, this strategy can work inversely with the underlying asset’s price rising after they agree to a lower price.
Whereas, speculation on derivatives is motivated by profit — not mitigating risk.
How Does This Apply to Commercial Real Estate?
In real estate, a property derivative will differ in value according to the changes in the value of an underlying real estate asset (e.g. an index).
One example of how to use a property derivative is by making a total return swap of the National Council of Real Estate Investment Fiduciaries Index, which is split into each property sector. This derivative will allow investors to take a position in a different property sector to which they may not already own. For example, swapping the returns from leisure real estate with industrial real estate.
Property derivatives allow investors to strategically change their portfolio, for up to three years, based on speculation or hedging risk against an underlying asset.