What Are Underlying Securities?
Underlying securities are the fundamental financial assets upon which derivative contracts derive their value. These are the primary investment instruments, such as stocks, bonds, commodities, currencies, interest rates, or market indices, that exist independently in the financial market. The concept of underlying securities is central to understanding derivatives, which are specialized financial contracts whose price movements are directly tied to the performance of these underlying assets. This falls within the broader category of Investment Instruments and Securities analysis.
An underlying security provides the basis for an investor to gain exposure to an asset's price fluctuations without necessarily owning the asset itself. For example, an options contract might give the holder the right to buy or sell shares of a specific company's stock, where that stock is the underlying security. Similarly, a futures contract might obligate the parties to buy or sell a certain quantity of a commodity like crude oil, making crude oil the underlying security.
History and Origin
The concept of underlying securities is intrinsically linked to the evolution of financial markets and, more specifically, to the development of derivative contracts. Early forms of derivative trading, such as forward contracts on agricultural products, can be traced back centuries, where the underlying asset was a physical commodity. These agreements allowed producers and consumers to lock in prices for future delivery, effectively managing price risk management.
Modern organized exchanges for trading such contracts began to emerge in the mid-19th century. For instance, the Chicago Board of Trade (CBOT), established in 1848, formalized grain trading through standardized futures contracts. The Chicago Mercantile Exchange (CME), founded in 1898 as the Chicago Butter and Egg Board, expanded to include a wider array of agricultural and then financial products. In 1961, the CME launched its first futures contract on frozen pork bellies, followed by live cattle futures in 19645, 6. The introduction of financial futures on foreign currencies in 1972 and interest rate futures in 1975 marked a significant turning point, expanding the range of underlying securities beyond physical commodities to include financial instruments4. These innovations laid the groundwork for the complex derivatives markets seen today, all reliant on the existence and reliable valuation of their underlying securities.
Key Takeaways
- Underlying securities are the foundational assets that give value to derivative contracts.
- They can include tangible assets like commodities or intangible assets like market indices.
- The price of a derivative contract directly reflects the price movements and characteristics of its underlying security.
- Understanding the underlying security is crucial for assessing the risk management and potential returns of derivative instruments.
- Examples include shares of a company's stock for equity options or a specific currency pair for a foreign exchange future.
Formula and Calculation
While underlying securities themselves do not have a "formula" in the sense of a calculation that determines their inherent value (their price is typically determined by supply and demand in the market), they are critical inputs to the formulas used to price derivative contracts. For instance, the widely used Black-Scholes model for pricing European-style options relies heavily on the price of the underlying security.
The Black-Scholes Formula for a Call Option:
Where:
- ( C ) = Call option price
- ( S_0 ) = Current price of the underlying security
- ( K ) = Strike price of the option
- ( r ) = Risk-free interest rate
- ( T ) = Time to expiration (in years)
- ( N() ) = Cumulative standard normal distribution function
- ( d_1 ) and ( d_2 ) are intermediate calculations:
Where:
- ( \ln ) = Natural logarithm
- ( \sigma ) = Volatility of the underlying security's returns
The current price of the underlying security ((S_0)) is a direct input into this formula, illustrating its foundational role in derivative valuation. Without an observable price for the underlying, the derivative's theoretical value cannot be determined.
Interpreting the Underlying Securities
Interpreting underlying securities involves understanding the specific characteristics and market dynamics of the asset that a derivative contract is based on. For example, if the underlying security is a stock, investors need to analyze the company's financial health, industry trends, and overall market sentiment, just as they would when making a direct investment in that stock. The volatility of the underlying security is particularly important, as higher volatility generally leads to higher option premiums, reflecting a greater chance of significant price movement.
For commodities, interpreting the underlying security involves assessing global supply and demand, geopolitical factors, and economic indicators that can influence its price. For market indices, the interpretation focuses on the performance of the basket of securities that comprise the index. A thorough understanding of the underlying security's fundamentals, technical indicators, and macroeconomic influences is paramount for any investor trading derivatives, as these factors directly drive the value of their derivative positions.
Hypothetical Example
Consider an investor, Alice, who believes that Company X's stocks, currently trading at $100 per share, will increase in value over the next three months. Instead of buying the shares directly, Alice decides to purchase a call options contract on Company X with a strike price of $105 and an expiration date three months away. In this scenario, Company X's stock is the underlying security.
If, at the expiration date, Company X's stock price rises to $115, Alice's option contract, which granted her the right to buy the stock at $105, is "in the money." She could exercise her option, buy the shares at $105, and immediately sell them in the open market for $115, realizing a profit (minus the premium paid for the option). Conversely, if the stock price only rises to $102 or falls, her option would expire worthless, as it would not be profitable to exercise it. This example demonstrates how the profitability of the derivative (the call option) is entirely dependent on the price movement of the underlying security (Company X's stock).
Practical Applications
Underlying securities serve as the cornerstone for various financial activities and strategies. In the realm of derivatives, they enable participants to engage in hedging strategies, protecting existing portfolios against adverse price movements, or to engage in speculation, aiming to profit from anticipated price changes. For instance, an airline might use futures contracts based on crude oil (the underlying security) to lock in fuel prices, thereby mitigating the risk of rising costs.
Beyond derivatives, underlying securities form the basis for many collective investment vehicles. For example, both Exchange-Traded Funds (ETFs) and Mutual Funds hold portfolios of underlying securities like stocks or bonds that they track or manage. Investors purchase shares in these funds, gaining diversified exposure to the underlying assets without owning them individually. The global derivatives market, built upon these underlying securities, is vast, with notional outstanding amounts reaching hundreds of trillions of dollars. In June 2024, the notional outstanding of global over-the-counter (OTC) derivatives was reported at $729.8 trillion, highlighting the immense scale at which underlying securities underpin financial contracts worldwide.3
Limitations and Criticisms
While underlying securities are fundamental to financial markets, the use of derivatives based on them can introduce complexities and potential criticisms, particularly concerning market stability and transparency. One major concern is the magnified impact that price swings in underlying securities can have on highly leveraged derivative positions. This leverage can amplify both gains and losses, potentially leading to significant systemic risks if large positions linked to underlying securities experience rapid, unfavorable movements.
Critics argue that the opaque nature of some over-the-counter (OTC) derivative markets, where transactions are not conducted on centralized exchanges, can obscure the true extent of exposure to specific underlying securities, making it difficult for regulators and market participants to assess potential vulnerabilities. A study analyzing the impact of financial derivatives markets on financial system stability found that while they can enhance market efficiency, their complexity and leverage effects can exacerbate market volatility during financial crises, leading to increased fragility in the financial system.2 This highlights the delicate balance between the utility of derivatives in risk management and their potential to introduce new forms of risk management challenges, especially when the underlying securities experience extreme price movements.
Underlying Securities vs. Derivative
The distinction between an underlying security and a derivative is crucial in finance. An underlying security is the actual asset that holds intrinsic value, such as a company's stock, a government bond, or a barrel of oil. It can be bought, sold, and owned independently. The U.S. Securities and Exchange Commission (SEC) defines a "security" broadly to include investment instruments like stocks and bonds.1
In contrast, a derivative is a financial contract whose value is derived from the performance of an underlying security. It is not the asset itself but an agreement to buy or sell the underlying asset, or based on its price, at a future date or under specific conditions. Derivatives include instruments like options, futures, and swaps. The confusion often arises because derivatives allow investors to gain exposure to the price movements of underlying securities without outright ownership, but they carry different risk profiles and structural characteristics.
FAQs
What are some common examples of underlying securities?
Common examples of underlying securities include individual stocks (like shares of Apple or Amazon), government and corporate bonds, commodities (such as gold, crude oil, or corn), foreign currencies (like the Euro or Japanese Yen), interest rates, and financial indices (like the S&P 500 or Dow Jones Industrial Average).
Why are underlying securities important for derivatives?
Underlying securities are essential for derivatives because they provide the benchmark or reference point from which a derivative's value is derived. Without an underlying asset or index, a derivative contract would have no basis for its existence or pricing. The price changes and characteristics of the underlying directly influence the derivative's value and profitability.
Can an underlying security itself be a derivative?
No, an underlying security generally refers to a primary financial asset that has independent value. A derivative is a contract whose value is derived from an underlying asset; it is not the underlying asset itself. While a derivative contract might reference another derivative (for example, an option on a futures contract), the ultimate underlying asset is always a non-derivative security or commodity.
How does the volatility of an underlying security affect a derivative?
The volatility of an underlying security significantly impacts the pricing of derivatives, especially options. Higher volatility in the underlying security typically leads to higher option premiums, as there is a greater probability that the underlying asset's price will move substantially, making the option more likely to become profitable for the holder. Conversely, lower volatility usually results in lower option premiums. This dynamic is a key consideration in derivative valuation and risk management.
Are underlying securities always publicly traded?
Not necessarily. While many common underlying securities like stocks, bonds, and widely traded commodities are publicly traded, an underlying security can also be a non-publicly traded asset, an index, or even a rate. For example, an over-the-counter (OTC) derivative might be based on a privately held company's equity or a specific interest rate benchmark not traded on an exchange. However, public trading generally provides greater price transparency and liquidity for the underlying.