What derivatives are written on: the main underlyings
Most derivatives reference one of five underlyings: equities, interest rates and bonds, currencies, commodities and credit. A few reference weather, longevity or crypto assets. Each family has typical users, from fund managers changing exposure to companies hedging costs.
Before this: What a derivative is
On the exam
- Define a derivative and describe basic features of a derivative instrument
Describe the basic features of derivatives by underlying. Expect: match an underlying to a user or purpose, classify a commodity as soft or hard, and recognize that an interest rate is an underlying but not an asset.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
What can a derivative reference?
Derivatives are grouped by the underlying that gives them their value. The usual five are equities, interest rates and bonds, currencies, commodities and credit. One contract can reference more than one: a cross-currency swap, for example, involves rates and currencies.
- Equities Memorize stocks, indexes, index volatility
- Investors Use it change market or sector exposure (index swaps, options)
- Issuers Use it pay staff with stock options and warrants
-
- Interest rates and bonds Memorize a rate is an underlying but not an asset
- Government bonds Know the idea futures may allow several bonds to be delivered
- Market reference rates Memorize SOFR, €STR, SONIA; used in swaps
-
- Currencies Memorize exchange rates, foreign government bonds
- Commodities Memorize
- Soft Memorize grown: wheat, coffee, corn, cattle
- Hard Memorize extracted: crude oil, copper, gold, aluminum
- Indexes Know the idea baskets of commodities
-
- Credit Memorize default risk of one issuer or an index
- Other Know the idea weather, longevity, cryptocurrencies: less common, harder to price
How do equity and interest rate derivatives work?
Equity derivatives reference a single stock, a group of stocks or an index. Options are the most common contract on single stocks, and index derivatives trade as options, forwards, futures and swaps. An equity (index) swap lets a manager pay the return on one index and receive the return on another index or on an interest rate, which raises or cuts exposure to a market or sector without trading the shares. Companies also grant stock options and warrants to staff: the warrant is an option to buy new shares from the issuer at a fixed price.
Interest rate derivatives reference bonds or rates. An interest rate is not an asset, but it is a fixed-income underlying. A swap is a firm commitment that converts fixed to floating exposure, or the reverse. An investor can lengthen or shorten portfolio duration without trading bonds, and an issuer can reshape the rate profile of its debt.
The most common underlying in rate swaps is a market reference rate (MRR), a short-term rate in line with what loans and other short-term borrowing pay. Survey-based Libor has been replaced by rates built from observed transactions: SOFR (Secured Overnight Financing Rate, a US overnight borrowing rate backed by Treasuries), €STR (euro short-term rate) and SONIA (Sterling Overnight Index Average).
What about currencies, commodities and credit?
Currency derivatives manage exchange rate risk. An exporter sells foreign currency forward to match a delivery contract; an investor can sell currency futures against a securities portfolio. Options, forwards, futures and swaps on exchange rates and foreign sovereign bonds are all used.
Soft commodities are agricultural products such as corn and cattle. Hard commodities are natural resources such as crude oil and metals. Producers and consumers use commodity derivatives to manage the price of a good; investors use commodity index futures for exposure without taking physical delivery.
A credit default swap (CDS) is based on the default risk of one issuer or of an index of issuers. It lets an investor change credit exposure separate from the bond market, or lets a bank offset the risk that a borrower defaults.
Weather and longevity derivatives , and those on cryptocurrencies, are less common and harder to price. Longevity matters to insurers and defined benefit pension plans that face longer lifespans.
Who uses what?
- A Japanese fund that expects technology shares to beat the Tokyo Stock Price Index (TOPIX) this quarter buys call options on a technology sector index. Equity, contingent claim.
- A Brazilian mining company with copper output due in nine months sells copper futures. Hard commodity, firm commitment.
- A German utility with a EUR 300 million floating-rate loan swaps to pay fixed. Interest rate, firm commitment.
- A bank with a large loan to one shipping company buys credit protection on it. Credit: pays out only on default.
Exam tip Name the underlying first; the purpose usually follows.
Go deeper Why bond futures allow several bonds to be delivered
A government has many bond issues outstanding, so one standardized futures contract cannot name a single bond. It allows several to be delivered. The fixed income modules show how the price is adjusted for that choice.
Go deeper From Libor to transaction-based rates
Libor was based on a survey of banks. Regulators replaced it with rates based on a daily average of actual transactions, so they are harder to manipulate and tied to real borrowing.
Go deeper Volatility derivatives
Options, futures and swaps can reference the realized volatility of an index. They let users trade the size of price swings separately from their direction.
Memorize this
MemorizeUnderlying, example, typical user
| Underlying | Examples | Typical use |
|---|---|---|
| Equities | stocks, indexes, volatility | change exposure; staff pay |
| Interest rates | bonds, SOFR / €STR / SONIA | change duration; fix floating debt |
| Currencies | exchange rates | exporters, importers, global investors |
| Commodities | soft, hard, indexes | producers, consumers; investors without storage |
| Credit | single issuer, credit index | add or cut credit risk; bank hedges a loan |
Memory hook Name the underlying first; the purpose usually follows. Soft = it grows or grazes (crops, livestock); hard = it comes out of the ground (energy, metals).
Know it cold Soft = agricultural and livestock. Hard = energy and metals. Credit derivatives reference default risk, not rates.
- Equities Memorize stocks, indexes, index volatility
- Investors Use it change market or sector exposure (index swaps, options)
- Issuers Use it pay staff with stock options and warrants
-
- Interest rates and bonds Memorize a rate is an underlying but not an asset
- Government bonds Know the idea futures may allow several bonds to be delivered
- Market reference rates Memorize SOFR, €STR, SONIA; used in swaps
-
- Currencies Memorize exchange rates, foreign government bonds
- Commodities Memorize
- Soft Memorize grown: wheat, coffee, corn, cattle
- Hard Memorize extracted: crude oil, copper, gold, aluminum
- Indexes Know the idea baskets of commodities
-
- Credit Memorize default risk of one issuer or an index
- Other Know the idea weather, longevity, cryptocurrencies: less common, harder to price
How it is asked
-
Soft or hard?
Futures on coffee and live cattle are derivatives on what?
Soft commodities. Trap: "hard", because commodity alone is not enough.
-
Duration change
A pension fund wants to lengthen duration without buying bonds. Which derivative?
Interest rate derivative (swap or bond futures). Trap: credit.
-
Remove default exposure
A bank wants to cut exposure to one borrower without selling the loan.
Credit default swap.
-
Match purpose to user
A ferry operator buys diesel futures. Underlying, and why?
Hard commodity (energy), to hedge rising fuel costs.
Exam traps
- Classing an interest rate future as a commodity contract. The underlying is a rate, not a good.
- Mixing soft (agricultural, livestock) and hard (energy, metals) commodities.
- Thinking credit derivatives reference interest rates. They reference default risk.
- Assuming an underlying must be an asset. A rate, an index or an event can be an underlying.
Checkpoint
3 exam-style questions. About 90 seconds each.
1Futures on coffee and live cattle are best described as derivatives on:
2A pension fund wants to lengthen the duration of its bond portfolio without buying bonds. It would most likely use a derivative on:
3A bank wants to reduce its exposure to the possible default of one large borrower without selling the loan. The most appropriate derivative is a:
Key takeaways
- Five big underlyings: equities, interest rates and bonds, currencies, commodities and credit.
- Soft commodities are grown; hard commodities are extracted.
- The underlying need not be an asset: a rate or an index works.
- A credit default swap pays out if a named borrower defaults.
All Derivatives formulas, every lesson
Practice exam-style questions on Derivatives and Derivative Markets
Questions about this lesson?
Where this comes back
- Forwards, Futures, Swaps, Options and Credit Derivatives Derivatives
- Derivative Benefits, Risks and Uses Derivatives
- Natural Resources: Land, Timber, Farmland and Commodities Alternative Investments
Questions candidates ask
What are the main types of derivative underlyings?
Equities, interest rates and bonds, currencies, commodities and credit. Weather, longevity and cryptocurrencies are less common. Contracts can also reference more than one underlying, such as a cross-currency swap.
What is the difference between soft and hard commodities?
Soft commodities are agricultural products such as corn, coffee and cattle. Hard commodities are natural resources that are extracted, such as crude oil, copper and gold.
Can an interest rate be the underlying of a derivative?
Yes. An interest rate is not an asset, but it is a common underlying. Swaps on a market reference rate such as SOFR are used to change duration or to convert floating debt to fixed.
Spotted an error? Tell us and we will fix it.