Definition
The term underlying asset refers to a commodity, financial instrument, or security specified in a derivative contract. The underlying asset is the primary driver of the price paid for a derivative.
Explanation
Also referred to as the underlying security, the underlying asset is the object that is being sold or purchased via an option contract or derivative. For example, the underlying asset in a contract can be a common stock, a commodity such as corn, a currency, or even a market index.
An option provides the holder with the right, but not the obligation, to buy or sell the underlying asset on or before the contract's expiration date at the option's strike price. While the price paid for a derivative is a function of time, the primary driver of the price paid or received when buying or selling an option is the value of the underlying asset. This is the reason options are referred to as derivatives; they derive their value from the value of the underlying asset.
Example
An investor is interested in purchasing a call option for Company ABC's common stock. A call option gives the holder the right to buy Company ABC's common stock at the option's strike price. If the investor were to purchase a call with a strike price of $50.00, and the current market price of Company ABC's common stock were $60.00, they would pay at least $10.00 per share for this call option.
Related Terms
transaction cost, trading pit, tick size, adjusted futures price
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