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An underlying asset is a term used in finance to refer to the security or commodity that gives value to a derivative contract. A derivative contract is an arrangement for the exchange of money between two parties that is based on the value or performance of an underlying asset.
A call option, for instance, is a type of derivative contract that offers the buyer the right, but not the duty, to purchase an underlying asset at a particular price within a predetermined window of time. The underlying asset may be any marketable asset, including a stock, a bond, a currency, or another monetary unit. The price movement of the underlying asset will determine how valuable the call option is.
An index, like the S&P 500 or the Dow Jones Industrial Average, can also be an underlying asset. A group of securities or commodities' performance is measured by an index. A derivative contract known as an index option allows the buyer or seller the ability to benefit from changes in an index.
Investors and traders who wish to hedging their risks or speculate on future market movements must understand what an underlying asset is and how it influences the value of a derivative contract.
