The Underlying: What a Derivative Contract References

The underlying is the thing a derivative contract references: the asset, the rate or the published measure whose price the contract's value is read from. Holding the contract gives the holder no part of it. Three facts about it decide every figure in the contract, and they are what its price is now, where that price is read from, and whether it pays anything to whoever holds it.

A contract that promises to pay a difference has to be able to say which difference. Everything else is forced by that one requirement. To name a difference is to name a thing, a price for that thing, a moment at which the price is taken, and a place the price is taken from. Do all four and what has been named is the underlyingThe thing whose price a contract's value is read from. The underlying sits outside the contract and is not changed by it.. Leave any one of them vague and the document cannot settle, whatever else is in it.

The referenced things as markets are covered separately and are used here rather than rebuilt. Referencing something at all is the subject here: what a thing must have before it can be referenced, what the reference gives the holder, what it does not give them, and which single property of the referenced thing quietly decides every figure on the contract.

What is the underlying, stated completely enough to use?

The underlying is the thing the contract points at, and its price is the number the contract's value is read from. The shapes a referenced thing can take are wider than most readers expect, so the definition has to be wide too. There are three of them, and the third is the one that makes people stop and read the sentence twice.

The referenced thing can be an asset: something that can be held. There is a price for it, both sides can see that price, and on the final day a unit of it could physically pass from one side to the other. A second shape is the rate: a price for money over a stated period. Nobody holds a rate. A rate cannot be put in a warehouse and cannot be handed over on a Tuesday. The third shape is a measure: a published number that nobody holds at all, arrived at by somebody counting or averaging something and then publishing the result.

A contract can reference something that cannot be delivered, and when it does, it settles in cash against the number rather than by handing anything over. The third shape forces exactly that, and it retires the worry about where the referenced thing is kept. Two neighbours can settle a wager on how much rain fell last month without either of them ever holding any rain. A difference in rupees passes between them, computed from a published figure that neither of them controls. The arrangement is complete, it is settleable, and there is nothing physical in it anywhere.

The three shapes turn into a test that runs in a second. The question is whether anybody, anywhere, could hold the thing. If the answer is yes, a contract on it may settle either by delivery or in cash, and which of the two applies is a term written into the contract rather than something the thing itself settles. If the answer is no, the question is closed. Nothing exists to hand over, so the contract can settle in cash and nothing else. The shape of the referenced thing decides what settlement is even possible, and no clause anywhere in the document can add a possibility the thing does not have.

A contract that pays a difference rather than handing anything over is cash settledDescribes a contract that pays a difference in money on the final day instead of anything passing from one side to the other., and the phrase is worth having because it is a term of the contract rather than a description of the thing. Where the two sides wanted the difference and not the thing, an asset that could perfectly well be delivered is referenced by a contract that settles in cash anyway. The other way round cannot be done. Delivery cannot be written into a contract on something that has no existence as an object.

Does holding the contract give the holder any part of the thing?

No, and this is the sentence to carry away. A holder of a contract on the invented reference asset has no part of that asset whatsoever. The holder has a promise from the other side, and the other side has a promise from the holder. Two promises are the entire content of the position. A search for the asset in the holder's name would not find it. Nothing was ever there to find.

The position moves in step with the thing, and that makes the point easy to say and surprisingly hard to hold onto. Somebody watching their screen sees the referenced price rise and sees their own figure rise with it, and the natural conclusion is that they hold a claim on whatever it was that rose. They do not. The holder has a promise whose size is worked out from a number that also happens to be the price of something. The link runs one way: the price feeds the contract, and the contract feeds nothing back.

Nothing about the referenced thing changes because the contract exists. The mirror fact is missed at least as often as the first one. The contract does not move the thing's price, does not add to how much of it there is, and does not take any of it off the market. A thousand contracts referencing it produce a thousand promises and not one additional unit of anything. Agreeing today what a stall will pay for a sack of flour in three months creates no flour. The sacks that exist are the sacks that exist, and the agreement is a separate object that lives entirely between the two people who made it.

What does a thing need before a contract can reference it?

Three conditions, and stating them as three allows any candidate to be tested rather than a list of acceptable things memorised. When somebody describes an arrangement, the three are run against it.

First, there has to be a price both sides can observe. Not a price one side computes and tells the other. Not a price that exists in a spreadsheet somewhere in one party's building. A price that both of them can look at, independently, and read the same number from. Second, there has to be a stated moment at which that price is taken. A price is not one number, it is a stream of numbers through a day and across days, so a contract that says the price without saying when has named a stream and not a number. Third, there has to be a stated source the price is taken from. Two honest, careful people can look at the same thing at the same moment in two places and read two different true prices, and neither of them is lying.

Miss any one of the three and the contract cannot be settled, and the argument that follows is not an argument about finance at all: it is an argument about which number to use, and nobody can win that one. Every other clause in the document depends on that number, so no clause elsewhere rescues it. A contract on a thing with no observable price is therefore not a contract at all, however carefully everything else in it has been drafted. The drafting quality of the rest is irrelevant when the settlement points at nothing.

The household version is close to home. Two people agree that one will pay the other the difference if the price of a plot of land in their neighbourhood is higher next year than it is now. Nothing about that is dishonest, and both of them mean it. But land on that street changes hands perhaps twice a decade, there is no published figure, and next year they will be arguing about whose valuer to believe. The three conditions are not bureaucracy. Their whole job is to stop two people who trust each other from ending the year not trusting each other.

Which price is read, at which moment, and from where?

Readers skip the settlement line, and the settlement line decides who pays. Somewhere in every contract there is a sentence about how the final number is arrived at, and it reads like small print because it is written like small print. The sentence is not small print. On the final day, one number is taken, and every rupee that changes hands depends on it. The care that goes into that sentence deserves to match the care that went into the price agreed at the start.

The number taken on the final day is the settlement valueThe single price taken on the final day, at the stated moment and from the stated source, used to work out what each side owes., and the useful way to hold it is as a sequence rather than as a fact. The final day arrives, having been written into the contract on the day the contract was struck. The moment named in the contract arrives on that day. One price is taken, from the source the contract names on its face. And that one number then decides every rupee that moves. Four steps, and every one of them was settled long before anybody knew whether the number would be high or low. Settling them in advance is exactly why they hold.

Which assets, rates and measures may be referenced by an exchange traded contract at all, and how the settlement value is fixed on the final day and from which source, are set by the Securities and Exchange Board of India (SEBI) at sebi.gov.in. The arrangements under which a currency or an interest rate may be referenced sit with the Reserve Bank of India at rbi.org.in. All of that moves, so each requirement is confirmed at the authority and the site named for it.

Why does a payout to the holder change every figure?

Now the property that quietly decides the arithmetic, and it is the one property most readers never think to ask about. Everything below runs on one invented reference asset. Its spot priceWhat the underlying costs to buy today, as opposed to any price agreed today for a purchase on a later date. is Rs 2,000.00/-, financing costs 6.50 per cent a year, and it pays nothing at all to whoever holds it.

Watch what that last clause does. Because the asset pays nothing while it is held, the one year forward price is the spot price carried and nothing else. Rs 2,000.00/- with one year of financing at 6.50 per cent a year added to it is Rs 2,130.00/-. Multiply it rather than take it: Rs 2,000.00/- times one point zero six five is Rs 2,130.00/-, so the carryThe cost of holding the underlying from today until a later date. Here it is one year of financing and nothing else. is Rs 130.00/-. The Rs 130.00/- of carry is the entire gap between the two prices. Nothing has been taken out of it anywhere.

The general shape of the build keeps the term this asset does not have, so its position stays visible.

If the underlying did pay something to whoever held it, that holder would collect the payment, the payment would subtract from the carry, and the forward price could sit below the spot price. No payoutAnything the underlying hands to whoever holds it while they hold it. The invented reference asset hands over nothing. figure stands behind this guide, so the case is named rather than worked. An invented payout would put a number in front of a reader at exactly the point where it would be leaned on hardest, with nothing supporting it.

A payout is not an exotic feature. Naming it therefore matters more than working it. A reader who meets a forward price sitting below a spot price somewhere else, and who has never been told that a payout subtracts from the carry, will reach for the only explanation they have available. The only explanation they have available is that somebody expects the price to fall. A forward below a spot almost never means that, and the wrong turn is an expensive one.

What happens to the contract when the referenced price moves?

The two shapes behave differently, so there are two answers, and the second reaches only as far as the figures allow.

For a forward, the answer is one for one, and the reason is that the contract is a straight difference from a number agreed at the start. Say the price agreed is Rs 2,130.00/-. The long side holds the right and the duty to buy at Rs 2,130.00/- on the date, so its worth to them today is what the thing costs today less what that agreed payment is worth today. Move the referenced price by a rupee and nothing else changes, so the worth moves by a rupee.

For an option, the answer is not one for one, and how far short of one for one it falls depends on how far the referenced price sits from the strike and how much time is left. Working out that amount needs a measure of how much the underlying's price moves about, and this record holds no volatility figure of any kind. The movement is not one for one, and that is as far as the arithmetic here goes. How far an option's value moves is set out separately, where the inputs for it exist.

A rupee for a rupee is exact at the final date and is not the whole story before it, so the moment being worked at has to be stated. Suppose the spot price falls from Rs 2,000.00/- to Rs 1,920.00/-, a gap of Rs 80.00/- on a base of Rs 2,000.00/-, with a full year still to run. The forward price for a fresh one year contract is now Rs 1,920.00/- times one point zero six five, or Rs 2,044.80/-. The carry applies to the new spot price as well, so against the Rs 2,130.00/- that was agreed the gap is Rs 85.20/-, not Rs 80.00/-.

The two gaps are not in conflict, and seeing why is worth a minute. The Rs 85.20/- is a gap between two forward prices, both of them payable a year from now. The Rs 80.00/- is a gap between two present worths. Discounting Rs 85.20/- for the one year still to run, at 6.50 per cent a year, gives Rs 80.00/- exactly. The value of the contract already struck moved by that same Rs 80.00/-. So the value of a contract in hand moves a rupee for a rupee at any moment. The price quoted for a brand new contract moves a little more than that, and the difference between the two is a year of carry. Written as the gap between two stated prices with its base attached, every move of this kind stops being confusing.

What is not the underlying, and what does the mix-up cost?

Three numbers sit close enough to the referenced price to be mistaken for it, and each confusion produces a different kind of wrong answer. Naming them takes a paragraph and saves a great deal.

The first is the contract's own quoted figure. A contract can change hands at a price of its own, and that price is not the number the contract settles against. The quoted figure and the referenced price are two different quantities that happen to live near each other. The second is the amount posted against the position. A margin of 8.0 per cent, a teaching figure, puts Rs 160.00/- against Rs 2,000.00/- of exposureThe amount of the underlying a position actually stands against, which is what a move in the referenced price is applied to.. The Rs 160.00/- stands behind the promise. The promise does not reference it. The third number is the notionalThe amount the payments under an arrangement are multiplied by. A notional never changes hands, and a notional is not a price.: the amount payments are multiplied by. A notional never changes hands at all, and how an arrangement built on one is taken apart is set out separately.

The first confusion is the expensive one. Marking a position each day against the contract's own quoted figure instead of the referenced price measures the wrong quantity every single day, and produces wrong numbers rather than merely muddled ones. Not occasionally, and not by a small amount that averages out. The quoted figure is a different quantity, so the error does not wash away over a week. Once a reader has been told to look, the Rs 160.00/- posted and a notional look nothing like a price, so the second and third confusions are usually caught.

Why is there only one reference asset here?

Because the record behind this guide contains exactly one. A reader who has followed this far will ask the obvious next question almost without noticing: what happens when somebody holds a contract on one thing while already having something slightly different, and do the two move together?

The question is real, and it matters more than most of what is set out here. One invented reference asset stands behind these figures and no second one, so the gap between two referenced things cannot be worked here, and an invented second asset would supply a figure that nothing supports. The gap between two referenced things is set out separately, with the material it needs.

Should anybody reference one?

A contract's requirements from the thing it references can now be stated exactly, and the next question is whether to be in one at all. No general treatment answers that. The answer requires four things, and at most two of them are here.

1. The exposure the position is being held against,and whether the referenced thing is actually the thing at issue. A position on the wrong reference is not a smaller version of the right one; it is a different position with its own behaviour.
2. What could be afforded if the referenced price went the other way.Circumstances no general treatment can know decide that one entirely.
3. The whole range of prices that could arrive, and how likely each one is.No probability and no distribution stands behind this guide, so nothing whatsoever can be said about this one.
4. Whether that thing may be referenced at all.SEBI at sebi.gov.in sets that, and the Reserve Bank of India at rbi.org.in sets it for a currency or an interest rate. The question has an answer, and the answer sits with those authorities.

Understanding a mechanism is not a reason to use it, and the three conditions set out above test whether a contract can settle at all rather than whether it suits anybody. Settling and suiting are separate questions, and running them together is how a clear explanation turns into an unstated nudge.

Who sets the requirements named here?

The reference asset here is invented.
Educational material. Not advice on any investment, tax, budget or market position.