What's the difference between an underlying asset and a derivative contract in trading?
In derivatives trading, the term "underlying asset" refers to the financial instrument that a derivative represents, ultimately determining its value. On the other hand, a derivative contract is an agreement between two parties based on the value of this underlying asset.
Underlying Asset:
- It's the primary financial instrument, like stocks, bonds, indices, currencies, or commodities, which forms the basis for the derivative contract.
- Essentially, it's what provides the value to the derivative.
- An example of an underlying asset would be a specific stock or commodity.
Derivative Contract:
- This is an agreement to buy or sell the underlying asset at a specific price on a predetermined date.
- Its value is derived from the underlying asset.
- For instance, a futures trader may buy or sell a contract promising to deliver an underlying stock on a certain future date.
In a nutshell, while the underlying asset is the actual financial instrument being traded, the derivative contract is an agreement based on that instrument's expected future value.
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