An underlying security is a stock, bond, commodity, or other financial instrument on which derivative instruments, such as futures contracts, options, or warrants, are based. The value of these derivative instruments is directly influenced by the performance of the underlying security. So, when the value or price of the underlying security changes, it affects the derivative’s price as well. For example, call options on Company A’s stock gives you the right to buy the stock at a specific price. Here, Company A’s stock is the underlying security.
1. What is a derivative instrument?
A derivative is a financial security with a value reliant upon or derived from, an underlying asset or group of assets. The derivative itself is a contract between two or more parties, and its price is determined by fluctuations in the underlying asset.
2. Can anything be an underlying asset?
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Not everything. An underlying asset is often a physical commodity or a financial instrument such as stocks, bonds, currencies, or market indexes. The value and price of the underlying asset directly influence the derivative based on it.
3. How does a change in the underlying security’s price affect the derivative?
When the value of the underlying security changes, it directly impacts the derivative’s price. For example, if the underlying security’s price increases, a call option’s value might increase as well, assuming all other factors hold constant.
4. What is a call option?
A call option is a financial contract that gives the option holder the right, but not the obligation, to buy a stock, bond, commodity, or other instruments at a specified price within a specific time period.
5. What is the difference between a call option and a put option?
A call option gives the holder the right to buy an asset at a certain price within a specific period, whereas a put option gives the holder the right to sell an asset at a specific price within a specified time.