Underlying asset is a term that is used in the trading of derivatives, such as options on equities or stocks. Derivatives are financial instruments whose price is based on, or derived from, a separate asset. The underlying asset of a derivative is the financial instrument, such as a stock, a commodity, a futures contract, an index or a currency, on which the price of the derivative is based.
As an example, an option contract on a stock provides the holder of that contract with the right, but not the obligation, to buy or sell that stock for a determined amount, also known as the strike price, at a specified time in the future, which is known as the contract’s expiration. The underlying for this option contract is the stock of a particular company.
It is used for identifying the item in the agreement that gives a value to the contract. The investor has the right, or option, to buy the asset at a price agreed upon on a specific date. It will support the security that is involved in the agreement, where the parties involved have agreed to exchange the underlying as part of that derivative contract.
Underlying Asset Example
In a case that involves stock options, the underlying asset is the stock itself. As an example, for a stock option to purchase 10 shares of Company A at the price of $10 on September 14th, the underlying asset of the contract is the stock of Company A.
The underlying asset in the contract is the asset that is used for determining the option’s value when the contract is first created. The value of it can change before the contract’s expiration, which will affect the option’s value and help the option buyer to determine whether or not the option should get exercised.
An underlying asset can also be related to a stock market index, such as the S&P 500. In the case of an index, it will be comprised of all the common stock within that stock market index.