Underlier refers to a financial asset or instrument that serves as the basis for a derivative contract. It is the underlying asset on which the value of the derivative is derived. The derivative instrument, often called a derivative product, could be an option, futures contract, or swap contract, and its value is based on the performance or changes in value of the underlier.
The underlier plays a crucial role in derivatives trading as it determines the cash flows, payoffs, or settlement terms of the derivative contract. It provides insight into the risks and opportunities associated with the derivative instrument. Common types of underliers include stocks, bonds, commodities, market indices, currencies, interest rates, or other financial benchmarks.
For example, in options trading, the underlier is the security (such as a stock or an index) that the option gives the right to buy or sell at a specified price (the strike price) within a specific time period. The value of the option is determined by the price movement of the underlier.
Understanding the underlier is crucial for investors, traders, and risk managers to accurately assess and manage the risk exposure associated with derivative positions. By analyzing the underlier's historical data, market trends, and factors affecting its price, participants can make informed decisions about trading derivatives and hedging against price fluctuations in the underlier.
