Underlying asset
Family I · Instruments
Not to be confused with contract size, cfd, exchange rate.
Underlying asset is the reference instrument that a derivative contract is written on. Its price, level or performance determines the cash flows and settlement value of the derivative. The underlying itself is not necessarily bought or sold when the derivative is traded.
Role in derivatives
Every derivative has an underlying. Common examples include shares, exchange-traded funds, stock indices, government bonds, interest rates, currencies, and physical commodities such as crude oil or gold. The derivative's contract specifications define the quantity, quality and delivery terms of the underlying.
The underlying may trade on an exchange or over the counter. Its price is observed in the market and used to calculate the derivative's value, margin requirements and settlement amount.
Worked example
The underlying index level is not directly received or delivered; the futures contract settles in cash based on the index's movement.
Variations
The eligible underlying assets for a given derivative depend on the exchange, jurisdiction and contract. Some derivatives reference a basket or a custom index rather than a single instrument. Settlement method, trading hours and position limits also vary by product and venue.
Often confused with
- contract size
- Contract size is the fixed quantity of an underlying asset represented by one derivative or spot contract, expressed in units, shares, barrels, or a notional amount.
- cfd
- A contract for difference (CFD) is a bilateral derivative agreement in which the seller pays the buyer the difference between the current value of an underlying asset and its value at contract time, or vice versa, without either party owning the underlying asset.
- exchange rate
- An exchange rate is the price of one currency expressed in units of another, determined in foreign-exchange markets and used to convert values between the two monetary areas.