Underlying is a term often used in the context of financial markets and derivatives trading. It refers to the asset or security that forms the basis of a derivative instrument, such as an option, futures, or swap.

The underlying asset provides cash flow to the derivative and is the asset that must be physically delivered when a contract or warrant is exercised. Typically, underlying assets are less volatile than their derivatives, since they form the base of the financial instrument and reflect its expected returns over time.

Common underlying assets includes stocks, currencies, commodities, bonds, and indices. For example, an index-based ETF (exchange-traded fund) is a derivative instrument that tracks the performance of an underlying index such as the Standard & Poor 500 (S&P 500).

In the case of convertible securities, the ‘underlying’ is the stock that can be exchanged for the note. Stock underlying a convertible bond is usually priced lower than the bond since the bondholder has to pay a premium to convert the bond into stock (and thus enjoy the potential upside of owning the stock rather than the bond).

In derivatives trading, the concept of underlying is very important, since it affects the cash flow to the derivative and thus determines the value of the derivative instrument. Therefore, it is important for traders to understand the nature of the underlying asset and its characteristics in order to gain an understanding of the risk and return associated with the instrument.

In summary, underlying refers to the asset or security that is the basis of a derivative instrument and provides cash flow to the derivative. Common underlying assets includes stocks, currencies, commodities, bonds, and indices, and understanding the characteristics of the underlying asset is crucial in order to understand the risk and return associated with a derivative instrument.