What is an 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.
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.
Classifying Underlying Securities
The different kinds of underlying securities, along with their associated derivative instruments, are frequently classified according to the type of investment risks that they are subject to. For example, stocks and commodities are subject to both systematic and unsystematic market risk, along with general economic risk.
The investment risks that bondholders or investors in other debt instruments are most focused on include default risk (also referred to as counterparty risk), interest rate risk, and credit risk.
The term “underlying securities” is frequently used interchangeably with the term “underlying assets.” Both underlying securities and underlying assets refer to things that financial derivatives are based on. However, the terms are not precisely synonymous.
A security refers to a negotiable financial instrument that, at least potentially, also comes with some type of monetary value. Virtually all securities can also be referred to as assets – but not all assets exist in the form of securities.
Significance of Underlying Security
The underlying is necessary to determine the pricing of derivatives. An underlying security gives derivatives their value. It enables investors to use options along with the concept of the underlying assets to identify and hedge risks.
Suppose when you purchase options to track the price movements of future stocks, you are actually trying to limit your downside risks associated, and at the same time allow unlimited upside potential. More or less, all derivatives are based on an underlying asset or security, irrespective of whether the derivative is common or rare.
To use an option and its underlying asset in the most advantageous way, you need to do your research well to speculate and hedge away the risks associated.
Why Are Underlying Securities Important?
Underlying securities give derivatives (such as options) much of their value. Investors use options and the concept of underlying assets to speculate and hedge risk.
For example, when you purchase options to speculate on future stock price movements, you are trying to limit your downside risk, while allowing for unlimited upside potential.
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.