Definition: An underlying asset is the security of a derivative contract. This could be a stock, bond, or other financial instrument that gives a derivative value.
What Does Underlying Asset Mean?
What is the definition of underlying asset? The underlying is a fundamental concept in derivatives trading because it allows investors to speculate risk and purchase options to limit the downside risk of future stock price movements. In addition, it represents the component of the agreement that provides value to the contract.
For instance, an investor who buys an option contract on a stock has the right to buy or sell the underlying asset (in this case the stock) at the strike price at maturity to realize a profit. Therefore, the UA represents the stock involved in a derivatives contract, which the parties agree to exchange. An UA can be stock, index, commodity or currency, and the price may be directly correlated (call option) or inversely correlated (put option) to the price of the derivative.
Let’s look at an example.
Example
Kelly owns 200 shares of a technology company, which currently trade at $82.45. On August 20, she buys a call option on the technology stock at a strike price of $92 and pays $300 (the option contract covers 100 shares, and it costs $3). The UA is the stock of the technology company.
On October 20, the stock price has risen to $100, so Kelly decides to exercise her option and buy 200 shares for $92 and sell them on the open market for $100. Her profit on the underlying asset will be 200 x $100 – 200 x $92 = $1,600 – $300 = $1,300. If the stock price had dropped to $80, Kelly would not exercise her option, and she would incur a total loss of $300, the premium of the option.
Therefore, the value of the underlying security fluctuates according to the movements in stock price. Hence, it may change before the maturity of the contract, affecting the value of the option and helping the holder to decide whether the option will be exercised or not.
Summary Definition
Define Underlying Assets: Underlying asset means the financial instrument that a derivative derives it value.
