Contingent Claims
With Options, Profit Is Generated if Another Related Event Occurs
Unlike forward commitments, where parties are obligated to complete a contract, contingent claims allow a party the flexibility of not engaging in the future transaction.
Contingent claims are the type of derivatives which generate payoffs provided that some other related market event occurs. More commonly, such derivatives are referred to as options. By definition, an option is a financial instrument that provides one party with the right to either buy or sell an underlying asset at a predetermined price at a specified point in the future.
Types of Options
There are two types of options: call options and put options. A call option gives its holder the right, but not the obligation, to buy an underlying asset; while a put option also gives its holder the right, and not the obligation, to sell an underlying asset at a fixed price at some point in the future. That fixed price is also referred to as an exercise price or strike price, while the date by which an option contract is set to expire is called an expiration date.
Options are in essence contingent claims because option holders have time until expiration to decide whether market and other conditions are favorable to exercising an option, or not. In other words, option profits depend on or are contingent upon whether a market or an economic event is taking place.
Unlike forward commitments, which are in essence true commitments to buy or sell an underlying asset, options give their holders the right to buy or sell. Of course, there is a price that has to be paid for that right, which is called the option premium, or simply the option price.
Now, since an option buyer acquires the right to buy or sell an underlying after paying the option premium, the seller of an option potentially has the commitment to sell or buy the underlying asset. If an option buyer has the right to buy, the option seller may be obligated to sell the underlying. Conversely, if an option buyer has the right to sell, the option seller may be obligated to buy the underlying.
Options Markets
Both call and put options can be customized and traded on the over-the-counter markets, or they can be standardized and exchange-listed. Meaning, option buyers and sellers can create their own terms and conditions to a contract, and they can go to an options exchange and trade standardized options.
As was the case with forward contracts, buyers of over-the-counter options are subject to option sellers defaulting if and when a buyer decides to exercise an option. But since the buyer of an option is not obligated to do anything, other than to pay the option premium, the option seller is not subject to the option buyer defaulting. Of course, in case of standardized options, the risk of the seller defaulting is virtually non-existent. The seller’s performance is guaranteed by its clearinghouse and the procedure called daily marking-to-market.
Other Financial Instruments Containing Options
There is a number of financial instruments that contain embedded options, and which are thus considered a form of contingent claims. For example, a convertible bond offers an option-like feature to its holder to convert the bond into a common stock if the stock appreciates in market price. In contrast, if the stock depreciates in price, the convertible bond holder does not have to do anything. In essence, without being directly invested in the stock that is underlying the convertible bond, the bond holder has the right to participate in the stock’s potential gains, as well as the right to avoid any potential losses.
Asset-backed securities also contain a type of options, whereby a claim is made on a pool of mortgages, loans or bonds that are typically put together by a financial institution and sold as a portfolio. Often, the borrowers who issued the pool of asset-backed securities have the option of paying off their debts early should interest rates fall considerably, and to refinance a new loan at lower rates. This right is called a prepayment feature and it is a hugely valuable option to a borrower.
