Underlying Security
An Underlying Security refers to the asset or security on which a financial derivative (such as options, futures, swaps, etc.) is based. It forms the foundation of the derivative's value. For example, the underlying security of a stock option is a specific stock, and the underlying security of an index future is a specific stock index. Underlying securities can include various asset types, such as stocks, bonds, commodities, currencies, interest rates, and market indices. Investors trade derivatives based on the underlying securities to achieve purposes like hedging, speculation, or arbitrage. Understanding the characteristics and market performance of the underlying security is crucial for the effective use of derivatives.
Definition: An Underlying Security is the asset or security on which a financial derivative (such as options, futures, swaps, etc.) is based. It forms the basis of the derivative's value. For example, the underlying security of a stock option is a specific stock, and the underlying security of an index future is a specific stock index. Underlying securities can include stocks, bonds, commodities, currencies, interest rates, market indices, and more.
Origin: The concept of underlying securities emerged with the development of financial derivatives. In the 1970s, financial markets began to introduce derivatives like options and futures, and underlying securities became widely recognized and used as the core elements of these tools.
Categories and Characteristics: Underlying securities can be categorized as follows:
- Stocks: Individual company stocks, such as Apple Inc. shares.
- Bonds: Government or corporate bonds, such as U.S. Treasury bonds.
- Commodities: Physical commodities, such as gold and oil.
- Currencies: Different national currencies, such as the U.S. dollar and the euro.
- Interest Rates: Financial instruments based on interest rates, such as LIBOR.
- Market Indices: Composite performance of a basket of stocks, such as the S&P 500 index.
Specific Cases:
- Case 1: An investor buys a call option on Apple Inc. stock, where Apple Inc. stock is the underlying security. If the stock price of Apple Inc. rises, the value of the call option will also increase.
- Case 2: An investor purchases a futures contract based on gold, where gold is the underlying security. If the price of gold rises, the value of the futures contract will also increase.
Common Questions:
- Question 1: What is the relationship between underlying securities and derivatives?
Answer: Underlying securities form the basis of the value of derivatives. The price and performance of derivatives directly depend on the market performance of the underlying securities. - Question 2: How to choose the appropriate underlying security?
Answer: When choosing an underlying security, consider its market performance, risk characteristics, and your investment goals and risk tolerance.
