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Underlying

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The term underlying generally refers to the asset that a derivative contract is written upon. However, it is not required that the underlying be an asset; in fact, an underlying can be a group of assets, an interest rate, a commodity, a share of stock, or even another derivative. In an options exchange, the underlying refers to the security that may be bought or sold at the contract price. Likewise, on a futures exchange, the underlying is the asset that must be bought or sold at the agreed upon price. In this manner, the value of the underlying at execution determines the gains or losses that are realized from possessing the derivative at that point in time. The price of many derivative contracts can then be determined by looking at the current price and implied volatility of the underlying along with the risk free rate, time to maturity, and strike price of the option.



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