What Is Underlying Security?
An underlying security is a stock or bond on which derivative instruments, such as futures, ETFs, and options, are based.It is the primary component of how the derivative gets its value.
Key Takeaways
- An underlying security is a stock or bond on which derivative instruments, such as futures, ETFs, and options, are based.
- In most cases, the underlying security is the item which must be delivered by one party in the derivative contract and accepted by the other party.
- Traders use derivatives to either speculate on, or hedge against, the future price movements of the underlying security.
Understanding Underlying Security
In derivative terminology, the underlying security is often referred to simply as "the underlying." An underlying security can be any asset, index, financial instrument, or even another derivative. The infamous collateralized debt obligations(CDOs) and credit default swaps(CDS), which were front and center in the Financial crisisof 2008, are also derivatives that depend on the movement of an underlying.
The role of the underlying security is merely to be itself. If there were no derivatives, traders would simply buy and sell the underlying. However, when it comes to derivatives, the underlying is the item which must be delivered by one party in the derivative contract and accepted by the other party. The exception is when the underlying is an index, or the derivative is a swap where only cash is exchanged at the end of the derivative contract.
There are many widely used and exotic derivatives, but they all have one item in common which is their basis on an underlying security or underlying asset. Price movements in the underlying security will necessarily affect the pricing of the derivative based upon it.
For example, a call option on Alphabet, Inc. (GOOGL)stock gives the holder the right, but not the obligation, to purchase Alphabet stock at a price specified in the options contract. In this case, Alphabet stock is the underlying security.
Traders use derivatives to either speculate on, or hedge against, the future price movements of the underlying. The more complex a derivative, the more significant the degree of speculation and hedging. For example, options on futures are bets on the future price of the futures contract, which in itself isa bet on the future price of the underlying.
Underlying Security Example
Let's say we are interested in buying a call option on Microsoft Corp. (MSFT). Buying a call gives us the right to buy shares of MSFT at a certain price during a certain period of time. Generally speaking, the value of the call option will increase alongside an increase in the share price of MSFT. Because the call option is a derivative, its price is tied to the price of MSFT. In this case, MSFT is the underlying security.
The underlying is also crucial to the pricing of derivatives. The relationship between the underlying and its derivatives is not linear, although it can be. Generally speaking, for example, the more distant the strike price for an out-of-the-money option is from the current price of the underlying, the less the option price changes per unit of movement in the underlying.
Also, the derivative contract may be written so that its price may be directly correlated, or inversely correlated, to the price of the underlying security. A call option is directly correlated. A put option is inversely correlated.
FAQs
Besides stocks and mortgage loans, other financial instruments that are underlying securities for various financial derivatives include bonds, currencies, interest rates, and market indexes.
What is an example of an underlying stock? ›
If company A is trading at $5 and the strike price is hit at $3, the price of the stock is trending up, the call is theoretically worth $2. In this case, the underlying is the stock priced at $5, and the derivative is the call priced at $2.
What is an underlying asset with an example? ›
Summary. Underlying asset is an investment term that refers to the real financial asset or security that a financial derivative is based on. Underlying assets include stocks, bonds, commodities, interest rates, market indexes, and currencies.
What is an example of an underlying derivative? ›
Underlying assets give derivatives their value. For example, an option on stock XYZ gives the holder the right to buy or sell XYZ at the strike price up until expiration. The underlying asset for the option is the stock of XYZ.
What is the underlying security? ›
An underlying security is a stock or bond on which derivative instruments, such as futures, ETFs, and options, are based. In most cases, the underlying security is the item which must be delivered by one party in the derivative contract and accepted by the other party.
What is an example of underlying? ›
She was not sure what his underlying motives were. The joke did not obscure the underlying seriousness of her point. The underlying reasons for these differences will be explored in depth in the next chapter. Their policies have resulted in a definite underlying improvement in the economy.
What does underlying meaning mean? ›
The obvious meaning of underlying refers to something beneath something else. But the word carries a more subtle meaning, that of something hidden but important, something that shapes the meaning or effect of something else, without being explicit itself.
What is underlying asset in simple words? ›
Definition: An underlying asset is the security on which a derivative contract is based upon. The price of the derivative may be directly correlated (e.g. call option) or inversely correlated (e.g. put option), to the price of the underlying asset.
What is the meaning of underlying items? ›
Items that determine some of the amounts payable to a policyholder. Underlying items can comprise any items; for example, a reference portfolio of assets, the net assets of the entity, or a specified subset of the net assets of the entity.
What is an example of an underlying cost? ›
There are several types of underlying costs:
- Direct Material Costs: These are costs related to the raw materials used in production.
- Depreciable Costs: These are the costs of tangible assets depreciated over time, like machinery or buildings.
Underlying Value means a specific value that is equal to a certain difference as specified by a calculation. Seen in 2 SEC filings. Underlying Value means an amount determined by the calculation agent on each trading day according to a certain formula.
Which is an example of the underlying assets of an asset backed security? ›
For example, asset-backed securities have been built based on cash flows from movie revenues, royalty payments, aircraft landing slots, toll roads, and solar photovoltaics. Just about any cash-producing vehicle or situation can be securitized into an ABS.
What is the biggest underlying issue with derivatives? ›
The main drawbacks of derivatives include counterparty risk, the inherent risks of leverage, and the fact that complicated webs of derivative contracts can lead to systemic risks.
What are the 5 examples of derivatives? ›
Five of the more popular derivatives are options, single stock futures, warrants, a contract for difference, and index return swaps. Options let investors hedge risk or speculate by taking on more risk. A stock warrant means the holder has the right to buy the stock at a certain price at an agreed-upon date.
What is the meaning of underlying current? ›
1. a current, as of water or air, flowing below another or beneath the surface. 2. an underlying tendency, opinion, etc., usually one that is kept hidden and not expressed openly.
Which is an example of the underlying assets of an asset-backed security? ›
For example, asset-backed securities have been built based on cash flows from movie revenues, royalty payments, aircraft landing slots, toll roads, and solar photovoltaics. Just about any cash-producing vehicle or situation can be securitized into an ABS.
What are examples of security? ›
Security relates to a financial instrument or financial asset that can be traded in the open market, e.g., a stock, bond, options contract, or shares of a mutual fund, etc. All the examples mentioned belong to a particular class or type of security.
What are the four types of securities? ›
Types of securities
- Equity securities. Equity securities, commonly known as stocks or shares, represent ownership in a company. ...
- Debt securities. ...
- Hybrid securities. ...
- Derivative securities. ...
- Asset-backed securities.
Items that determine some of the amounts payable to a policyholder. Underlying items can comprise any items; for example, a reference portfolio of assets, the net assets of the entity, or a specified subset of the net assets of the entity.
