Underlying Security
Key takeaways
- An underlying security is the asset (stock, bond, commodity, index, currency, or even another derivative) on which a derivative is based.
- The derivative’s value and settlement depend on the price or performance of the underlying.
- Derivatives are used to speculate on or hedge against future movements in the underlying; settlement may be physical delivery or cash, depending on the contract.
What it is
The underlying security (often called “the underlying”) is the primary asset that gives a derivative its value. Common underlyings include equities, bonds, commodities, currencies, financial indices, and other derivatives. Complex instruments—such as collateralized debt obligations (CDOs) or credit default swaps (CDSs)—also rely on underlying assets or exposures.
How it works
- Price linkage: The price of a derivative moves in response to changes in the underlying’s price.
- Settlement: Some derivatives require physical delivery of the underlying at contract maturity; others are cash-settled (common with index derivatives and many swaps).
- Correlation: A derivative can be structured to move in the same direction as the underlying (direct correlation, e.g., call options) or in the opposite direction (inverse correlation, e.g., put options).
- Nonlinearity: The relationship between changes in the underlying and changes in the derivative’s price is not always linear. Factors such as strike price, time to expiration, volatility, and interest rates affect sensitivity (for options, this sensitivity is described by Greeks such as delta and gamma).
Example
Buying a call option on Microsoft (MSFT) gives the buyer the right, but not the obligation, to purchase MSFT shares at a specified strike price before expiration. MSFT is the underlying. If MSFT’s share price rises, the call option generally gains value. The size of that gain depends on factors like how far the option is in or out of the money and how much time remains until expiration.
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Why it matters
- Risk management: Investors and institutions use derivatives to hedge exposure to price changes in underlyings without necessarily transacting in the underlying asset itself.
- Speculation and leverage: Derivatives allow traders to take leveraged positions on expected moves in underlying prices with less capital outlay than buying the underlying outright.
- Market structure: Understanding what underlies a derivative is essential to assessing its risk, potential payoff, and how it will behave under different market conditions.
Bottom line
The underlying security is the fundamental asset that determines a derivative’s value, payout, and settlement method. Whether used for hedging, speculation, or transferring risk, derivatives derive their economic meaning from the behavior of their underlying.