By Peet Serfontein
Whether an investor is buying equities, trading futures or investing in structured notes, the performance and behaviour of the underlying asset ultimately determines the outcome. Understanding what underlying assets are, how they function and how they behave is essential for informed investment decision-making in the context of structured products.
What is an underlying asset?
An underlying asset is the primary financial instrument or reference on which another financial product is based. It determines the value and risk of that product. For example, when an exchange traded product or a structured note is linked to the FTSE/JSE Top 40 Index, that index is the underlying asset. Similarly, when an option is written on a specific share such as a major banking or mining share, the share itself is the underlying asset.
The main types of underlying assets
1. Equities and equity indices
In South Africa, equities are the most used underlying assets. These can include individual shares listed on the Johannesburg Stock Exchange (JSE), such as banks, retailers, industrials and resource companies, or local and global equity indices like the FTSE/JSE Top 40 Index or the S&P 500.
Equity indices are popular underlying assets because they provide diversified exposure and reduce the impact of company-specific risk. However, some indices can be quite concentrated, meaning that a small number of large companies can have a significant influence on the performance of the index. This concentration affects volatility and must be considered when using indices as underlying assets.
2. Bonds and interest rates
In South Africa, government bonds issued by National Treasury serve as key references for fixed-income markets. Bond-based underlying assets are sensitive to changes in inflation expectations, fiscal conditions and monetary policy. As a result, their performance often reflects broader macroeconomic conditions in South Africa.
Interest rate instruments, such as the repo rate set by the South African Reserve Bank or money-market benchmarks, are often used as underlying assets in interest rate derivatives and income-focused structures.
3. Commodities
South Africa is a resource-rich economy, making commodities a particularly relevant underlying asset class. Precious metals such as gold and platinum, as well as industrial commodities, are frequently used as references. Commodity underlyings are influenced by global supply and demand dynamics, geopolitical developments and currency movements, especially the rand. For South African investors, commodity underlyings often introduce an indirect exposure to offshore markets, as commodity prices are typically set in US dollars.
4. Currencies
Currencies, particularly the rand, are widely used as underlying assets. Currency-linked instruments may reference the rand against major currencies such as the US dollar or euro. Exchange-rate underlyings are influenced by interest rate differentials, trade balances, political stability and global risk sentiment. Currency underlyings are especially important in South Africa because exchange-rate movements can significantly affect returns on offshore investments and inflation dynamics.
Why underlying assets matter
Underlying assets are central to understanding both risk and return. They determine how an investment behaves under different market conditions and how it interacts with the broader economy.
Underlying assets in structured products and derivatives
Underlying assets play a particularly important role in structured products and derivatives.
In structured products, the choice of underlying asset determines the product's risk profile and suitability. A product linked to a broad equity index behaves very differently from one linked to a single share or a currency pair. Features such as barriers, participation rates and coupons are all calibrated based on the expected volatility and correlation of the underlying asset.
In derivatives, the underlying asset defines the contract's value. Futures, options and swaps all rely on accurate pricing and behaviour of the underlying. Small changes in the underlying asset can lead to significant changes in derivative values, amplifying both gains and losses.
Choosing appropriate underlying assets
Selecting suitable underlying assets requires aligning market exposure with investment objectives and risk tolerance. Investors should consider:
In South Africa, this assessment must also account for local economic conditions and global influences.
Practical example: Underlying assets in a selection of FNB Structured Products
FNB's structured investment products provide investors with exposure to major global equity indices and sector-themed benchmarks while offering defined capital protection features.
For example, the FNB 100 and 80 CapitalPreserver Autocall notes link performance to the MSCI World Index, a broad developed-markets equity benchmark representing large and mid-cap stocks across 23 markets, allowing investors to participate in global share price growth over a five-year term with full or partial capital protection at maturity. Other autocall tranches extend this concept by referencing thematic indices such as the Bloomberg Luxury Series 1 Decrement Index and the Bloomberg Europe DM Top 30 Basic Resources Decrement Index, which track portfolios of global luxury and resource-sector shares, respectively.
These indices serve as the underlying assets that determine payoff outcomes, with autocall features enabling early maturity if underlying index levels meet predefined performance criteria, as well as capital protection ensuring investors receive some or all their initial investment back at the end of the term, even in challenging markets.
