In a CFE preparatory class, a student asked us this question. Do all financial derivatives have contingent claims embedded in them? We wanted to refer him to John Hull’s introductory text on Financial Derivatives and move on. Then it dawned on us.

The concept of "contingent claims" may seem trivial and utterly basic to most of us who are in the banking industry or deal with financial markets on a daily basis. However, to the uninitiated, the notion of “contingent claim” is a moot point about financial derivatives, one that gives colour to their risk profiles.

Not all financial derivatives are contingent claims.

An option is a contingent claim, as are many financial derivatives which have optionality embedded in them. The payoff of all vanilla and exotic options are contingent, i.e. dependent, on the underlying asset price or the security reaching a certain target price or satisfying certain conditions.

A swap, a forward contract or an FRA, on the other hand, is not a contingent claim even though each is a financial derivative.

A contingent claim is a payoff that is "contingent" on the asset price (or the underlying security) reaching a certain target level or satisfying a certain condition. For example, if a stock is currently trading at 100 and John sells a financial product to Megan, whereby, if after one year the stock price is at 120 or above, Megan shall receive $1 from John, otherwise, she will receive nothing, then John is the seller of a contingent claim and Megan is the buyer of that contingent claim. And for buying that “contingent” claim, Megan pays say, $0.25 (25 cents) to John today.

Here, Megan’s positive payoff (i.e. profit), if any, from holding this financial product is contingent on the stock price reaching 120 at maturity. Only if the stock price reaches 120 will she make any profit or get any payoff ($1) otherwise, she will get nothing. In other words, she is acquiring a “right” and for that she has to pay a price (25 cents) today.

Note that, Megan’s claim, which may happen in future, is “contingent” on a certain event and is conferring a “right” upon her; this claim has a cost associated with it which needs to be separated from the claim and paid to John today.

This is an example of a financial option, or simply option, which is a contingent claim.

Now, let’s say that John and Megan enter into a transaction whereby John agrees to deliver 100 ounces of gold to Megan after one year at the price of US$1,250 per ounce. In this transaction, which is also a derivative product, there is nothing “contingent” about Megan’s claim. At the end of one year, Megan has a claim on 100 ounces of gold and she is obligated to buy that (i.e. take delivery of 100 ounces of gold) from John at the given price; and that the same time, John is obligated to sell, i.e. deliver, 100 ounces to Megan at the end of one year. In this transaction, i.e. the buying and selling of the product, no cash changes hands today and Megan does not pay anything to John at the time of the settlement (start) of the transaction. Yet, it is a firm obligation on part of both. John has to deliver 100 ounces of gold to Megan after one year and Megan has to buy, i.e. take delivery of 100 ounces of gold and pay John US$1,250 for that. There is a contractual obligation on part of John to deliver and Megan to take delivery of 100 ounces of gold after one year at a certain price.

There is a cost associated with this transaction but that cost is not separated from the transaction and is built into the transaction. For example, gold may be trading at US$1,100 per ounce today but Megan will be taking delivery of 100 ounces at a rate of US$1,250, which is higher than the price today. However, this difference of US$150 is built into the one year “forward” price that Megan is going to pay to John.

Note that even though no cash changes hand today between John and Megan, i.e. Megan does not have to pay John anything today to buy this product both of them have a claim on each other that is "non-contingent". There is nothing contingent about this claim. It is certain. And both of them are taking a credit risk (or "counter-party" risk) on each other.

This is an example of a forward contract.

This claim, the forward contract, however, can become contingent, i.e. an option, if the product is structured in a different way. For example, John could sellthe product to Megan in a way that gives her the right to buy (take delivery of) a 100 ounces of gold from John at a price of US$1,250 after one year and for acquiring this right she pays to John, say, US$50 per ounce today. In this case, if gold is trading at US$1,100 per ounce today, then Megan will only take delivery of 100 ounces of gold from John after one year if it trades at US$1,250 or more. Otherwise, it would not make any commercial sense to her. In fact, rationally speaking if she pays US$50 per ounce for acquiring this right from John, then she would only take delivery of 100 ounces of gold after one year, if it trades at a price of US$1,300 per ounce or more for her to break even or make a profit.

Now, the claim has become contingent. Contractually, Megan is not obligated to take delivery of 100 ounces of gold from John. However, it is almost certain that she will do so, only if the one year price of gold is higher than today’s price (plus the cost of her purchase), that is, contingent on the price of the gold being higher than a certain level (today’s price) she will take delivery of 100 ounces of gold.

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