What it means
A derivative is a contract whose value comes from something else. That something else is the underlying.
The derivative does not usually give you the asset itself, though in some contracts it can, but it moves in price as the underlying moves. Underlyings can be many different things.
They include shares, bonds, commodities such as oil or wheat, currencies, interest rates, stock indices and even the weather or credit events. Each has its own risks and its own pricing, so a user of a derivative must understand the underlying before using the contract.
The link between the derivative and its underlying is the heart of risk management. A company that fears a rise in fuel prices can buy a contract linked to fuel, so that gains on the contract offset higher costs.
The hedge works only when the underlying is closely matched to the real exposure, and any mismatch is called basis risk. Pricing models use the current level of the underlying, its volatility, time to expiry and interest rates.
A simple measure called delta shows how much the derivative price is expected to change when the underlying moves by one unit. This is why traders watch the underlying market first.
Some contracts settle in cash, based on the underlying's price, while others settle by physical delivery. A finance team should know which applies, because it changes cash needs, storage and operational arrangements.
The underlying also determines the risks that remain after a hedge is in place. If the contract is linked to a benchmark price while the business buys at a local price, the two can drift apart.
Reviewing the match between the underlying and the real exposure each quarter is a simple discipline that avoids unpleasant surprises.
In practice
Real-world examples.
Example
An airline buys a contract whose underlying is jet fuel. If fuel rises by $10 a barrel, the gain on the contract helps pay for higher fuel bills, which stabilises the airline's costs. Finance reports the contract and the fuel purchases together so the net cost is easy to see.
Example
A fund manager sells futures whose underlying is a stock index to protect a $20,000,000 portfolio. If the index falls, the gain on the futures offsets some of the loss on the shares. The manager accepts that the hedge will also give up gains if the market rises.
Example
A company with a floating-rate loan enters an interest rate swap. The underlying is the reference rate used for the floating payments, and the swap fixes the company's interest cost. The treasurer can then budget the interest bill with confidence for the whole term.
Formula
Calculation
Approximate change in derivative value = Delta x Change in underlying price
A call option has a delta of 0.5, meaning it moves about half as much as the underlying. The underlying share price rises from $100 to $102, a change of $2. The option's price is expected to rise by 0.5 x 2 = $1. If the option cost $4.00 before the move, it would be worth about 4.00 + 1.00 = $5.00 afterwards.Case study
Seen in the real world.
Westmoor Foods is an illustrative, fictional bakery group that buys large amounts of wheat. Its finance director wanted to protect margins against a sudden rise in wheat prices and arranged futures contracts with wheat as the underlying.
The first year, wheat prices rose by 20%, and the gains on the futures offset about 90% of the extra raw material cost. In the second year, prices fell, and the contracts lost money while the company enjoyed lower purchase costs.
The illustrative lesson was that the hedge locked in stability and not profit. The director explained to the board that the contract and the underlying were designed to move together, so the loss on one was matched by a gain on the other. The board accepted this, and asked the director to report the hedge result next to the purchase cost every quarter.
Watch out
Common mistakes.
- Buying a derivative without understanding the underlying, which makes it impossible to judge the risk.
- Assuming the derivative and the underlying always move one for one, when delta, time and volatility affect the relationship.
- Choosing an underlying that does not match the real exposure, which leaves basis risk.
Questions
People also ask.
Is the underlying always a physical asset?
No, it can be a financial asset, a rate, an index, a credit event or even a weather measure.
What is the difference between the underlying and the derivative?
The underlying is the reference asset, and the derivative is the contract whose value is based on it.
Do I have to own the underlying to use a derivative?
No, most users trade derivatives without ever owning the underlying, and many contracts settle in cash.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%