LeoGlossary: Underlying

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The word "underlying" refers to something that is not immediately apparent or obvious, but is fundamental or basic to the nature or existence of something else. It suggests there is a deeper, more essential element or cause that is not readily visible on the surface.

Some key points about the meaning of "underlying":

It describes something that is present but not easily seen or noticed, like an "underlying trend" or "underlying meaning".
Underlying refers to something that is fundamental, basic, or essential, such as an "underlying cause" or "underlying issues".
It can indicate something that has priority or precedence, like an "underlying mortgage" or "underlying claim".
The word suggests there is a deeper structure or foundation, as in "underlying word order" or "underlying rock".

In summary, "underlying" points to a more primary, foundational, or hidden element that shapes or influences the observable aspects of a situation, problem, or phenomenon. It describes what lies beneath the surface and forms the basis for what is seen or experienced.

Finance

In finance, the term "underlying" refers to the real asset or security that a financial derivative is based on. The key points about the meaning of "underlying" in finance are:

The underlying is the actual asset, such as a stock, bond, commodity, currency, or index, that determines the value of a derivative contract.
Changes in the price or value of the underlying asset directly impact the price or performance of the derivative.
Common examples of underlying assets include stocks (e.g. Reliance Industries), stock indices (e.g. Nifty 50), commodities (e.g. crude oil), currencies (e.g. USD/INR), and bonds (e.g. government securities).
Underlying assets are traded in the cash or "spot" markets, while derivatives based on them are traded on specialized exchanges, privately, or in over-the-counter markets.
Understanding the characteristics and trends of the underlying asset is crucial for participants in derivatives markets to make informed trading decisions and manage risk.

Derivative Value

The value of a derivative security is directly tied to the performance and price movements of its underlying asset. Changes in the price or value of the underlying asset have a direct impact on the price or performance of the derivative.

For example, in an options contract, the value of the option is determined by the current market price of the underlying stock, bond, or other asset. If the underlying asset increases in value, the value of a call option on that asset will also increase, as the option holder has the right to buy the asset at a lower predetermined price. Conversely, if the underlying asset decreases in value, the value of a put option on that asset will increase, as the option holder has the right to sell the asset at a higher predetermined price.

Similarly, in a futures contract, the value of the futures contract is directly tied to the spot price of the underlying commodity, currency, or other asset. As the price of the underlying asset fluctuates, the value of the futures contract changes accordingly.

Examples of Underlying Assets

Here are the key examples of underlying assets in finance:

Stocks - Individual company stocks are a common underlying asset for derivatives like options and futures contracts.
Bonds - debt securities like government, municipal, and corporate bonds can serve as underlying assets.
Exchange-Traded Funds (ETFs) - ETFs tracking various market indexes are used as underlying assets for derivatives.
Market Indexes - Broad market indexes like the S&P 500 or NASDAQ Composite can be the underlying for index-based derivatives.
Commodities - Physical commodities such as gold, silver, oil, and agricultural products are frequently used as underlying assets.
Currencies - Major global currencies like the U.S. Dollar, EURO, and Japanese Yen are common underlying assets for currency derivatives.
interest rates - interest rate benchmarks like LIBOR or government bond yields can serve as the underlying for interest rate derivatives.

The key point is that the underlying asset is the fundamental financial instrument or security that determines the value of a derivative contract. Changes in the price or performance of the underlying directly impact the derivative's price and profitability.

General:

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