Final answer:
The term 'underlying' in derivative financial instruments refers to the asset on which the derivative contract is based. It determines the value and performance of the derivative.
Step-by-step explanation:
In the context of derivative financial instruments, the term 'underlying' refers to the asset or financial instrument on which the derivative contract is based. It represents the reference point for the derivative's value and performance. The underlying can be various financial assets, such as stocks, bonds, commodities, or currencies.
For example, if someone purchases a call option on a stock, the stock is the underlying asset. If the stock price increases, the value of the call option also increases.
Understanding the underlying is essential in derivative trading, as it determines the risks and potential rewards associated with the derivative contract.