Underlying Security

Definition

An underlying security is a stock, bond, commodity, or any other asset upon which a derivatives contract, such as a futures or options contract, is based. It is the asset that the derivative seller has the obligation to deliver to or buy from the derivative buyer, on or before a specified date. The price of the derivative often depends on the price performance of this underlying security.

Phonetic

The phonetic pronunciation of the term “Underlying Security” is:Un·der·ly·ing Se·cu·ri·ty, /ˈʌndərˌlaɪɪŋ sɪˈkyʊərɪti/

Key Takeaways

Underlying Security plays a fundamental role in the world of finance, particularly in derivatives trading. It’s critical to understand key aspects of Underlying Security. Here are three main takeaways:

1. Definition: Underlying Security refers to the financial asset (such as stocks, commodities or bonds) upon which a derivative’s price is based. It’s the asset that must be delivered when a derivative contract, like a put or call option, is exercised.
2. Role in Derivatives: Derivatives derive their value from Underlying Securities. The performance and fluctuation of an Underlying Security directly affects the value of the associated derivative. Using derivatives, investors can speculate on future price movements of Underlying Securities without actually owning the asset.
3. Risk Management: Underlying Securities allow for risk management strategies in investment. By buying derivatives linked to Underlying Securities, investors are able to hedge against potential losses, which may occur due to adverse price movements in these Underlying Securities.

Importance

Underlying Security is a crucial term in business and finance as it forms the foundation of various derivative products such as options, futures, and other financial instruments that derive their value. It refers to the specific financial asset (like stocks, bonds, commodities, currencies, etc.) that these instruments are built upon. This concept is pivotal because it helps to assess the risk and reward scenario of the derivative investment. The price and the performance of the underlying security directly influence the value of the derivatives. Therefore, understanding the underlying security can lead to more informed investment decisions about buying or selling these financial instruments.

Explanation

The underlying security serves a critical function in the world of finance and investing, particularly within derivatives trading. Essentially, an underlying asset is utilized as a benchmark to establish the price level or settlement conditions for derivatives such as options, futures contracts, and swap contracts. These financial contracts allow investors to speculate on the pricing fluctuations of the underlying security without necessarily owning it, thereby enabling them to participate in various markets and manage risk effectively. When a derivative is purchased, it’s not the actual security that is bought; instead, it’s a contract that derives its value from the price movement of the underlying security. For example, an option gives the holder the right (but not the obligation) to buy or sell the underlying security at a specified price within a certain time frame. Hence, underlying securities are used to determine the value and potential payoff of these derivatives. In effect, they allow for a broader range of investment strategies beyond straightforward buying or selling of securities, providing opportunities for hedging, leverage, and speculation.

Examples

1. Shares in a Company: In options contracts, the underlying security often refers to the specific shares in a business. For example, if an investor purchases a call option for Tesla, Inc. (TSLA), the underlying security for the option contract is specifically the shares of Tesla, Inc. The investor has the right (but not obligation) to purchase these shares at a predetermined price (strike price) until the option’s expiration date. 2. Treasury Bonds: Treasury bonds (T-Bonds) can be an underlying security for futures contracts. For example, the Chicago Board of Trade (CBOT) offers a futures contract on U.S. Treasury bonds. In this case, the obligated party will have to deliver the specific bond upon the contract’s expiration. 3. Exchange-Traded Funds (ETFs): ETFs are often the underlying security for options contracts. SPDR S&P 500 ETF Trust (SPY) is one example where it represents the underlying security for related options contracts. The contract gives the holder the right to buy or sell the ETF shares at a specific price before the contract expires.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Derivatives
• Options Contract
• Spot Price
• Strike Price
• Futures Contract

Sources for More Information

• Investopedia
• Corporate Finance Institute
• Fincash
• Nasdaq