In finance, the underlying of a derivative

Derivative (finance)

A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...

 is an asset

Asset

In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...

, basket of assets

Basket (finance)

A basket is an economic term for a group of several securities created for the purpose of simultaneous buying or selling. Baskets are frequently used for program trading.Certain specific products can be seen as specialized "baskets"....

, index

Index (economics)

In economics and finance, an index is a statistical measure of changes in a representative group of individual data points. These data may be derived from any number of sources, including company performance, prices, productivity, and employment. Economic indices track economic health from...

, or even another derivative, such that the cash flows of the (former) derivative depend on the value of this underlying. There must be an independent way to observe this value to avoid conflicts of interest

Conflict of interest

A conflict of interest occurs when an individual or organization is involved in multiple interests, one of which could possibly corrupt the motivation for an act in the other....

.

According to the Financial Accounting Standards Board's FASB Statement of Financial Accounting Standards No. 133 (FAS 133) - Accounting for Derivative Instruments and Hedging Activities, an underlying is a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable (including the occurrence or nonoccurrence of a specified event such as a scheduled payment under a contract). An underlying may be a price or rate of an asset or liability but is NOT the asset or liability itself.

Examples

For example, in a stock option to buy 100 shares of Nokia

Nokia

Nokia Corporation is a Finnish multinational communications corporation that is headquartered in Keilaniemi, Espoo, a city neighbouring Finland's capital Helsinki...

 at EUR 50 in April 2011, the underlying is a Nokia share. In a futures contract

Futures contract

In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...

 to buy EUR 10 million 10 year German Government Bonds, the underlying are the German Government bonds. Other examples are stock market index

Stock market index

A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....

es such as the Dow Jones Industrial Average

Dow Jones Industrial Average

The Dow Jones Industrial Average , also called the Industrial Average, the Dow Jones, the Dow 30, or simply the Dow, is a stock market index, and one of several indices created by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow...

 and Nikkei 225

Nikkei 225

The , more commonly called the Nikkei, the Nikkei index, or the Nikkei Stock Average , is a stock market index for the Tokyo Stock Exchange . It has been calculated daily by the Nihon Keizai Shimbun newspaper since 1950. It is a price-weighted average , and the components are reviewed once a year...

, for which the underlying are the common stock

Common stock

Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...

s of 30 large U.S. companies and 225 Japanese companies, respectively.

Options on futures derivatives are an example of derivatives whose underlying is also a derivative. For example, Euro-Bund options (OGBL) are trade on Eurex

Eurex

Eurex is one of the world's leading derivatives exchanges, providing European benchmark derivatives featuring open and low-cost electronic access globally...

and their underlying is the Euro-Bund futures contract (FGBL).