What is an 'Underlying Asset'
An underlying asset is a term used in derivatives trading, such as with options. A derivative is a financial instrument with a price that is based on (that is, derived from) a different asset. The underlying asset is the financial instrument (such as stock, futures, a commodity, a currency or an index) on which a derivative's price is based.
BREAKING DOWN 'Underlying Asset'
For example, an option on a stock gives the holder the right to buy or sell the stock for a specified amount (strike price) at a certain date in the future (expiration). The underlying asset for the stock option contract is the company's stock.
An underlying asset can be used to identify the item within the agreement that provides value to the contract. The investor has the option, or the right, to buy the aforementioned asset at an agreed upon price on a particular date, known as the expiration. The underlying asset supports the security involved in the agreement, which the parties involved agree to exchange as part of the derivative contract.
Example of an Underlying Asset
In cases involving stock options, the underlying asset is identified as the stock itself. For example, in a stock option to purchase 10 shares of Company X at a price of $100 on September 15, the underlying asset is the stock in Company X. The underlying asset is the asset used to determine the value of the option as the contract is created. The value of the underlying asset may change before the expiration of the contract, affecting the value of option and assists the buyer in determining if the option should be exercised.
Understanding Derivative Contracts
A derivative contract is used in relation to options and futures. The price of the option or future is derived from the price of an underlying asset. In an option contract, a seller must either buy or sell the underlying asset to the buyer on the specified date at the agreed-upon price. The buyer is not obligated to purchase the underlying asset, but he can exercise his right if he chooses to do so. If the option expires, and changes in the market make the purchase unfavorable for the buyer, the buyer can then choose not to participate in the transaction.