Underlying Asset

Every derivative refers to something else. For a share option, the underlying asset is the share. For an oil futures contract, it is oil. For a currency forward, it is the exchange rate between two currencies. For an interest rate swap, it is an interest rate benchmark.

The value of the derivative rises and falls with changes in the underlying asset's price. For example, a call option on a company's shares becomes more valuable when the share price rises, because the right to buy at a fixed price is worth more.

The underlying does not have to be something you can hold. Derivatives can be based on stock market indices, interest rates, inflation rates, weather data or credit events such as a company defaulting.

In many derivatives, especially options and futures that are settled in cash, the underlying asset is never actually delivered. The contract is settled by paying the difference in value. Understanding the underlying asset, and what drives its price, is the first step in understanding any derivative.