Definition
An underlying security is the financial asset on which the value of a derivative, such as an option, futures contract, convertible bonds, or other financial instruments, is based. It is the primary security that must be delivered if the associated contractual financial options are exercised by the holder. This contrasts with the derivative itself, which is a secondary form of the financial instrument whose value is dependent on the primary underlying security.
Key Areas of Application:
- Options Trading: The underlying security could be a stock that must be delivered if a put or call option is exercised.
- Convertible Bonds: Common stock often acts as the underlying security for convertible bonds, where the bondholder can convert the bond to shares of the company.
- Warrants: A company’s stock that is issued as part of a warrant contract, providing the holder the right to buy shares in the future at a pre-determined price.
- Subscription Rights: These often pertain to common stock where rights are issued to current shareholders enabling them to purchase additional shares.
Examples
- Stock Options: A specific company’s stock would be the underlying security for any options contracts written on that company’s stock.
- Futures Contracts: Commodities such as gold, oil, or agricultural products serve as the underlying security for related futures contracts.
- Index Options: A stock index, such as the S&P 500, would be the underlying security for options that derive their value from that index.
Frequently Asked Questions (FAQs)
What is the role of the underlying security in derivative contracts?
The underlying security serves as the asset upon which the value of the derivative is based. When a derivative contract—like an option or a futures contract—is exercised, it’s the underlying security that must be delivered or received.
Can underlying securities be anything other than stocks?
Yes, underlying securities can include bonds, indexes, commodities, currencies, or other financial assets.
How do changes in the underlying security’s price affect derivatives?
The value of a derivative contract typically moves in response to changes in the price of the underlying security. For example, an increase in the price of a stock would generally increase the value of the call options on that stock.
What happens if the underlying security is not available at the time of the contract’s exercise?
In most cases, derivatives markets ensure the mechanisms required to fulfill delivery obligations. If the underlying security becomes unavailable (a rare occurrence), it could lead to cash settlement or other predefined resolutions within the contract terms.
Related Terms
Derivative
A financial contract whose value depends on the price of an underlying asset.
Option
A financial contract giving the buyer the right, but not the obligation, to buy or sell an asset at a specified price before a specified date.
Futures Contract
An agreement to buy or sell an asset at a future date for a price agreed upon at the time of the contract.
Convertible Bond
A type of bond that the holder can convert into a specified number of shares of the issuing company’s stock.
Warrant
A derivative that confers the right, but not the obligation, to buy or sell a security at a certain price before expiry.
Online References
Suggested Books for Further Studies
- “Options, Futures, and Other Derivatives” by John C. Hull
- “The Handbook of Fixed Income Securities” by Frank J. Fabozzi
- “Fundamentals of Futures and Options Markets” by John C. Hull
- “Options as a Strategic Investment” by Lawrence G. McMillan
- “Derivatives Markets” by Robert L. McDonald
Fundamentals of Underlying Security: Finance Basics Quiz
Thank you for exploring the concept of underlying securities with us! Mastering this understanding is crucial for achieving proficiency in financial and derivatives markets.
