What does ‘Underlying’ mean
Underlying, in equities, is the common stock that must be delivered when a warrant is exercised, or when a convertible bond or convertible preferred share is converted to common stock. The price of the underlying is the main factor that determines prices of derivative securities, warrants and convertibles. Thus, a change in an underlying results in a simultaneous change in the price of the derivative asset linked to it.
Explaining ‘Underlying’
There are two main types of investments: debt and equity. Debt must be paid back and investors are compensated in the form of interest payments. Equity is not required to be paid back and investors are compensated by share price appreciation or dividends. Both of these investments have specific cash flows and benefits depending on the individual investor.
Financial Derivatives
There are other financial instruments based solely on the movement of debt and equity. There are financial instruments that go up when interest rates go up. There are also financial instruments that go down when stock prices go down. These financial instruments are based on the performance of the underlying asset, or the debt and equity that is the original investment. This class of financial instrument is referred to as derivatives as it derives value from movements in the underlying. Generally, the underlying is a security such as a stock in the case of options, or a commodity in the case of futures.
An Underlying Example
Two of the most common types of derivatives are referred to as calls and puts. A call derivative contract gives the owner the right, but not the obligation, to buy a particular stock or asset at a given strike price. If company A is trading at $5 and the strike price is hit at $3, the price of the stock is trending up, the call is theoretically worth $2. In this case, the underlying is the stock priced at $5, and the derivative is the call priced at $2. A put derivative contract gives the owner the right, but not the obligation, to sell a particular stock at a given strike price. If company A is trading at $5 and the strike price is hit at $7, the price of the stock is trending down, the put is trading $2 in the money and is theoretically worth $2. In this case, the underlying is the stock priced at $5 and the derivative is the put contract priced at $2. Both the call and the put are dependent on price movements in the underlying asset, which in this case is the stock price of company A.
Pros and Cons of Underlying
Underlying is a type of investment that allows investors to invest in assets that are not directly traded on an exchange. For example, an investor might buy shares of a company that is not publicly traded. There are both pros and cons to this type of investment.
One of the main advantages of underlying is that it can provide access to investments that would otherwise be unavailable. For example, many startups are not publicly traded, so the only way to invest in them is through underlying. This can also be a disadvantage, as these investments may be more risky and difficult to liquidate.
Another advantage of underlying is that it can provide a higher return potential than more traditional investments. This is because underlying typically involves more risk; however, this higher potential return must be balanced against the increased risk.
The main disadvantage of underlying is the increased amount of risk involved. These investments are often more volatile and may be harder to liquidate in a pinch. Additionally, they may be less regulated than traditional investments, which could lead to fraud or other problems.
Overall, underlying can be a good way to access high-growth investments; however, it is important to understand the risks involved before investing.
What Happens When the Price of an Underlying Asset Increases?
