An Underlying Security refers to the financial instrument that must be delivered when a derivative contract, such as a put or call option, is exercised. In the context of securities, it is typically a common stock associated with various corporate-issued instruments, including subscription warrants, subscription rights, convertible bonds, preferred stocks, and incentive stock options.
Types of Underlying Securities
Options
In options trading, the underlying security is the stock or asset that must be delivered when the holder of a put or call option exercises their right. Specifically:
- Put Option: Grants the holder the right to sell the underlying security at a specified price within a set time frame.
- Call Option: Grants the holder the right to buy the underlying security at a specified price within a set time frame.
Convertible Bonds
A convertible bond is a type of debt security that can be converted into a predetermined number of shares of the issuing company’s common stock. The common stock, in this case, serves as the underlying security.
Subscription Rights and Warrants
- Subscription Right: A short-term privilege that allows existing shareholders to purchase additional shares in the company at a discounted price. The common stock that can be purchased is the underlying security.
- Subscription Warrant: A long-term instrument that gives the holder the right to buy the underlying shares at a specified price and date.
Preferred Stock
For preferred stocks that come with a conversion feature, the underlying security will be the common shares that these preferred shares can be converted into.
Incentive Stock Options (ISOs)
Incentive Stock Options (ISOs) are a type of employee stock option that can be granted only to employees. The underlying security in the case of ISOs is typically the common stock of the employer.
Significance of Underlying Securities
Understanding the concept of underlying securities is crucial for investors and traders because the value and performance of derivative instruments and other financial products are directly tied to these underlying assets.
Price Movements
The price of derivative instruments such as options and convertible bonds is significantly influenced by the price movements of their underlying securities.
Risk Management
Investors use derivatives involving underlying securities for hedging purposes to manage risk exposure related to the price fluctuations of the securities.
Example
Consider an investor who buys a call option for Company XYZ’s stock with a strike price of $50. If the investor decides to exercise the option, they must buy 100 shares (assuming one option contract represents 100 shares) of Company XYZ at $50 per share, regardless of the current market price. Here, Company XYZ’s stock is the underlying security.
Historical Context
The concept of underlying securities has evolved significantly over time, aligning with the development of the financial derivatives market. The Chicago Board Options Exchange (CBOE), established in 1973, played a crucial role in standardizing option contracts and promoting the importance of underlying securities in financial markets.
Related Terms
- Derivative: A financial contract whose value is derived from the performance of an underlying asset.
- Strike Price: The specified price at which the underlying security can be bought or sold in an option contract.
- Expiration Date: The date on which an option contract becomes void.
- Hedge: A strategy used to offset investment risk.
FAQs
What determines the value of the underlying security?
How is the underlying security delivered?
Are all underlying securities stocks?
Summary
Underlying securities are fundamental to financial markets, serving as the cornerstone for a variety of derivatives and other corporate financial instruments. Understanding their role helps investors and traders make informed decisions, manage risks, and capitalize on market opportunities.
References:
- Hull, John C. “Options, Futures, and Other Derivatives.” Pearson, 2017.
- Fabozzi, Frank J. “Handbook of Fixed-Income Securities.” McGraw-Hill Education, 2012.
- Chicago Board Options Exchange (CBOE). “Introduction to Options.” CBOE.
By understanding the comprehensive nature of underlying securities, investors and traders can effectively navigate the complexities of financial instruments and capitalize on the opportunities they present.
