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Derivatives are financial securities that get their value from an underlying asset or group of assets. These are contracts between two or more parties where the derivative’s value varies with fluctuations in the underlying asset. These assets may include stocks, bonds, currencies, interest rates, commodities, etc. Derivatives are prevalent in over-the-counter markets or exchanges.
There are various reasons why participants may use derivatives. These include hedging a position, speculating on an underlying asset’s movement, or giving leverage to holdings. They may come in various forms or types, such as forwards, futures, options, or swaps. Typically, however, they fall into one of two categories, contingent claims or forward commitments.
What is a Contingent Claim?
A contingent claim is a derivative that has a payoff that depends on the realization of an uncertain future event. Like any other derivative, contingent claims derive their value from the underlying asset. The payoff depends on some uncertain events realizing. Therefore, these derivatives also get their name from the contingency of those events.
Contingent claims may come in different types. These include options and modified versions of swaps, forward contracts, and futures contracts. However, vanilla swaps, forward, and futures do not constitute contingent claims. Instead, these are forward commitments, which is a derivative instrument and not a contingent claim.
Vanilla swaps are rare in practical usage. Therefore, it makes options the most prevalent type of contingent claim derivatives. Options represent the right to buy or sell the underlying asset at a specified price and date. Contingent claims are crucial in various models and theories. These are an important part of corporate finance as a valuation framework.
How does a Contingent Claim work?
In a contingent claim, one party receives the right to buy or sell an underlying asset from another party. However, they do not have an obligation to do so. Before the contract, both parties fix the purchase or sell price and the expiration date. Since there is no obligation involved, the deciding party will determine whether they want to exercise the right to buy or sell.
The payoff in the contract depends on the underlying asset reaching a target price or satisfying other conditions. In case it does so, the claim will go through. These types of claims are prevalent in options traded on an options exchange. In these cases, the contingent claim gets standardized to facilitate the speed of trade.
What are the types of Contingent Claims?
Contingent claims come in several types. Most prominently, these include options, where the payoff is contingent on the occurrence of an event. With options, one party has the right to buy or sell but no commitment. Similarly, contingent claims may include convertible bonds, where the holder can convert their bonds into equity instruments.
Contingent claims also come in the form of callable bonds, where the issuer has the option to call their bonds. Other examples of contingent claims include warrants, interest rate options, options on futures, asset-backed securities, and exotic options.
Derivatives are a type of financial security that derive their value from an underlying asset or group of assets. A contingent claim is a type of derivative that comes with a payoff that depends on the realization of an uncertain future event. There are various types of these derivatives. With contingent claims, one party gets the right to buy or sell an underlying asset, but there is no obligation to do so.
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