Underlying Asset

What Is an Underlying Asset?

An underlying asset is the security, commodity, currency, index, or other item whose price determines the value of a derivative. A derivative is a contract that has no independent worth. It takes its value from something else, and that something else is the underlying asset.

Common underlying assets include individual stocks, bonds, market indexes, currency pairs, interest rates, and physical goods such as crude oil, natural gas, gold, or wheat. A single underlying asset can support many different derivatives, each with its own terms.

How It Works

The relationship is direct. When the underlying asset's price rises or falls, the value of the derivative generally moves in a related way, though not always by the same amount. For example, a call option gives its holder the right, but not the obligation, to buy the underlying asset at a set strike price before a certain date. If the underlying price rises well above that strike, the option usually becomes more valuable.

Contracts also differ in how they settle. Some require actual delivery of the underlying asset. Others are settled in cash based on the difference between the contract price and the market price. Futures contracts on a stock index are often cash-settled, because delivering every stock in an index is impractical.

Why It Matters to Investors

The underlying asset is the true source of risk in a derivative. An investor holding an option on a stock is exposed to that stock's price movements, along with other factors such as time remaining until expiration and expected volatility. Because many derivatives provide leverage, a relatively small move in the underlying asset can produce a large percentage change in the derivative's value, in either direction.

Investors encounter the concept in exchange-traded funds and index funds, where returns are tied to the performance of an underlying index. Contract specifications and fund prospectuses typically identify the underlying asset and explain how it is used, which makes them a useful starting point for understanding what a product actually tracks.