When an investor purchases a call option for shares of Hindustan Unilever Limited (HUL), the underlying security is the shares of HUL. If the call option is exercised, the security to be delivered by the seller of the option is the specified number of shares of HUL. The term ‘underlying’ is used because though the instrument purchased is the call option, the value of the call option is derived from the value of the shares that are the subject matter of or lie beneath the face of the instrument. Apart from call options, depository receipts, put options, stock warrants, convertible securities, and stock options also have underlying securities.
Types of Underlying Securities
An underlying security could be an equity share, a commodity, a bond, a debenture, or even another derivative.
Importance
Any discussion about derivatives would have little or no meaning unless the underlying security is also known. Options and futures have no independent value but depend upon the value of the specified security. A change in the value of the underlying asset will always affect the decision of whether or not to exercise the option. When an investor purchases a call or a put option, he is speculating in the price of the shares, etc, described in the option or hedging his portfolio risk.
