The Underlying security meaning is considered the primary component based on which a derivative gets its value. Therefore, the value of a financial derivative depends largely on the value of an underlying security.
For instance, let’s say there is an option contract for Stock XYZ, and it offers an investor the right to purchase or sell the stock at the strike price until its expiration date. In this situation, Stock XYZ becomes the underlying asset.
There may be numerous common and exotic derivatives. However, all of them are based on an underlying asset or underlying security. This also means that the price of the derivative will be affected whenever the price of the underlying security goes up or down.
The underlying security is also termed simple as “the underlying”. Moreover, an underlying security can be any Financial Instrument, asset, index, or even another derivative. The more complex a particular derivative grows, the higher the degree of risk speculation and hedging would become.
Underlying securities are classified based on the type of investment risks each of them is subject to. For instance, commodities and stocks are subject to Market risks as well as a general economic risk.
The term “underlying securities” is often used interchangeably with “underlying assets”, as both of them refer to factors on which financial derivatives are based. However, that doesn’t necessarily mean that the two terms are precisely synonymous with each other.
The investment risks that are given priority by investors or bondholders in other debt instruments, include Default Risk (or counterparty risk), credit risk, and interest rate risk.
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A security denotes a negotiable financial instrument that comes with some kind of monetary value, at least potentially. Virtually speaking, all securities can also be known as assets. However, the difference is not all assets can be called securities. Because not all assets can exist in some kind of security.
Taking an example of assets like oranges and heating oil, we can safely say that they are not securities. But you can trade these assets via derivative instruments, including contracts, futures, options, CFD (contracts for difference), and forward contracts.
The underlying is necessary to determine the pricing of derivatives. An underlying security gives derivatives their value. It enables investors to use options along with the concept of the underlying assets to identify and hedge risks.
Suppose when you purchase options to track the price movements of future stocks, you are actually trying to limit your downside risks associated, and at the same time allow unlimited upside potential.
More or less, all derivatives are based on an underlying asset or security, irrespective of whether the derivative is common or rare. To use an option and its underlying asset in the most advantageous way, you need to do your research well to speculate and hedge away the risks associated.