Definition of Underlying Security
An underlying security is a financial asset, such as a stock or bond, upon which derivative instruments like futures, exchange-traded funds (ETFs), and options are based. In simpler terms, underlying securities serve as the foundation for various financial derivatives, determining their value and providing a basis for trading strategies.
Types of Underlying Securities
Stocks
A stock represents ownership in a corporation and constitutes a claim on part of the company’s assets and earnings. Stocks are a common type of underlying security for derivatives such as options and stock futures.
Bonds
A bond is a fixed income instrument that represents a loan made by an investor to a borrower. Bonds serve as underlying securities for various interest rate futures and bond options.
Functionality of Underlying Securities
Price Determination
The value of derivatives like options and futures is intrinsically linked to the price movements of the underlying security. This direct correlation allows traders to hedge risks or speculate on price movements based on underlying security performance.
Risk Management
Underlying securities are crucial in risk management strategies, providing a base from which financial instruments can be used to mitigate potential losses. For example, stock options can be employed to hedge against potential declines in stock value.
Examples of Underlying Securities
Call Options
A call option on a stock gives the holder the right, but not the obligation, to purchase the underlying stock at a specified strike price within a set time period.
Bond Futures
Bond futures are contracts obligating the buyer to purchase a bond at a predetermined price at a future date. The underlying security here is the bond itself.
Historical Context
The concept of underlying securities has been integral to financial markets for centuries. The development of sophisticated derivatives markets has enhanced the role of underlying securities, with modern financial instruments tracing their origins back to more straightforward asset holdings.
Applicability in Modern Finance
Investment Strategies
Investors leverage underlying securities through various channels such as ETFs, index funds, and mutual funds to create diversified portfolios and achieve different financial goals.
Hedging
Corporations and individual investors use derivatives based on underlying securities to hedge against adverse price movements, protecting their investments from market volatility.
Comparisons with Related Terms
Derivatives
While derivatives derive their value from underlying securities, they differ in that they do not confer ownership of the asset itself.
Arbitrage
Arbitrage involves taking advantage of price discrepancies between different markets for the same underlying security, providing risk-free profit opportunities.
FAQs
What is the difference between underlying securities and derivatives?
Underlying securities are the actual financial assets such as stocks or bonds, while derivatives are financial instruments whose value is based on the price movements of these underlying assets.
Can underlying securities be used to speculate?
Yes, traders often use derivatives based on underlying securities to speculate on future price movements, aiming to capitalize on predicted changes in asset value.
References
- Hull, J. C. (2017). Options, Futures, and Other Derivatives. Pearson Education.
- Black, F., & Scholes, M. (1973). The Pricing of Options and Corporate Liabilities. Journal of Political Economy.
Summary
Underlying securities play a pivotal role in the financial markets, serving as the foundational assets upon which various derivative instruments are based. By providing a basis for price determination and risk management, underlying securities enable diversified investment strategies and facilitate the hedging of potential losses. Understanding the intricacies of underlying securities and their applications is essential for navigating modern financial markets effectively.
