The security on which a derivative derives its value. For example, a call option on Company X stock gives the holder the right, but not the obligation, to purchase Company X’s stock at the price specified in the option contract. In this case, Company X’s stock is the underlying security.
Generally, an underlying security's value should be independently observable by both parties, so that there is no potential for confusion regarding the value of the derivative. Investors dealing in derivatives must closely research the underlying security in order to ensure that they fully understand the factors affecting the value of the derivative.
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