Underlying asset price risk is the potential for financial loss caused by adverse movements in the market value of the primary instrument on which a derivative contract is based.
Understanding underlying asset price risk
For Elephants trading derivatives like options or futures, the value of a position depends directly on another financial instrument. This primary instrument is the underlying asset. The risk that the price of the underlying asset moves against a trader is the main driver of profit and loss. If a trader holds a call option, a drop in the underlying price reduces the value of the option.
This risk applies across all global financial markets. An underlying asset can be a corporate stock, a physical commodity, a fiat currency pair, or a government bond. Traders measure this specific risk using delta. Delta is a metric that quantifies how much the price of the derivative changes for every one-unit move in the price of the underlying asset. High delta values indicate high exposure to underlying asset price movements.
Managing this price risk requires hedging. Market participants often buy or sell offsetting positions in the underlying market to neutralize their directional exposure. If an investor holds a portfolio of equity shares, they might buy put options to protect against the risk that the price of the underlying asset declines before they intend to sell.
Example
Imagine an agricultural cooperative run by Elephants who process peanut oil for international export. To lock in their raw material costs for the upcoming year, the Elephants buy peanut futures contracts on a commodity exchange. The underlying asset in this contract is the physical raw peanut.
The Elephants face underlying asset price risk on these contracts. If the global market price of raw peanuts falls heavily before the contract expires, the futures contracts the Elephants hold will decrease in value. The derivative position loses money because the price of the underlying asset moved in an unfavorable direction for the buyer of the futures contract.