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In finance, the underlying of a derivative is an asset, basket of assets, index, or even another derivative, such that the cash flows of the (former) derivative depend on the value of this underlying. There must be an independent way to observe this value to avoid conflicts of interest.
According to the Financial Accounting Standards Board (FASB)'s Statement of Financial Accounting Standards No. 133 (FAS 133) - Accounting for Derivative Instruments and Hedging Activities, an underlying is a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable (including the occurrence or nonoccurrence of a specified event such as a scheduled payment under a contract). An underlying may be a price or rate of an asset or liability but is not the asset or liability itself.
For example, in a stock option to buy 100 shares of Nokia at EUR 50 in April 2011, the underlying is a Nokia share. In a futures contract to buy EUR 10 million 10-year German Government Bonds, the underlying are the German Government bonds. Other examples are stock market indexes such as the Dow Jones Industrial Average and Nikkei 225, for which the underlying are the common stocks of 30 large U.S. companies and 225 Japanese companies, respectively.
Options on futures derivatives are an example of derivatives whose underlying is also a derivative. For example, Euro-Bund options (OGBL) are traded on Eurex and their underlying is the Euro-Bund futures contract (FGBL).
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