Underlying is a term used in finance and economics to refer to the basic asset or security that is the source of value for a derivative instrument. A derivative is a financial contract that derives its value from an underlying asset, such as a stock, bond, commodity, or currency.The underlying can be physical assets, such as commodities like gold or oil, or financial assets, such as stocks or bonds. It can also be indices, such as the S&P 500 or the NASDAQ, or currency exchange rates.Pros of having an underlying asset include increased market liquidity and transparency, as the price of the underlying asset is publicly available and can be easily tracked. Additionally, the underlying asset serves as a basis for pricing the derivative and can provide a level of stability and predictability to the derivative's value.Cons of having an underlying asset include increased risk, as the value of the derivative is dependent on the performance of the underlying asset. If the underlying asset performs poorly, the value of the derivative may also decline. Additionally, changes in market conditions can impact the performance of the underlying asset, leading to uncertainty and risk for the derivative.An example of an underlying asset is a stock. If an investor buys a stock option, the underlying asset is the stock itself. The option derives its value from the performance of the stock, and the price of the option is tied to the price of the stock. If the stock price rises, the value of the option will also rise, and vice versa.In conclusion, the underlying is a term used to refer to the basic asset or security that is the source of value for a derivative instrument. Pros of having an underlying asset include increased market liquidity and transparency, while cons include increased risk and dependence on the performance of the underlying asset. An example of an underlying asset is a stock, which serves as the basis for pricing a stock option.
