An underlying instrument is a financial security or asset upon which a derivative’s price is based. The term “underlying instrument” refers to the financial instrument that gives a derivative its value.
For instance, if you are dealing with a stock option, the underlying instrument would be the stock that the option controls. Similarly, in the case of a futures contract, the underlying instrument could be a commodity, like oil or wheat.
It’s important to note that the price of the derivative is derived from and is dependent on the price of the underlying instrument. For example, if the price of the underlying stock rises, a call option on that stock becomes more valuable. Similarly, if the price of the underlying commodity falls, a futures contract to sell that commodity at a set price in the future becomes more valuable.
The underlying instrument can be a variety of financial instruments such as stocks, bonds, commodities, currencies, interest rates, or market indexes. It can also be another derivative, leading to complex financial structures.