CONTINGENT CLAIMS
April 13th, 2009Contingent claims are derivatives in which the payoffs occur if a specific event happens. We generally refer to these types of derivatives as options. Specifically, an option is a financial instrument that gives one party the right, but not the obligation, to buy or sell an underlying asset from or to another party at a fixed price over a specific period of time. An option that gives the right to buy is referred to as a call; an option that gives the right to sell is referred to as a put. The fixed price at which the underlying can be bought or sold is called the exercise price, strike price, striking price, or strike, and is determined at the outset of the transaction. In this blog, we refer to it as the exercise price, and the action of buying or selling the underlying at the exercise price is called exercising the option. The holder of the option has the right to exercise it and will do so if conditions are advantageous; otherwise, the option will expire unexercised. Thus, the payoff of the option is contingent on an event taking place, so options are sometimes referred to as contingent claims.
In contrast to participating in a forward or futures contract, which represents a commitment to buy or sell, owning an option represents the right to buy or sell. To acquire this right, the buyer of the option must pay a price at the start to the option seller. This price is called the option premium or sometimes just the option price. In this blog, we usually refer to it as the option price.
Because the option buyer has the right to buy or sell an asset, the seller of the option has the potential commitment to sell or buy this asset. If the option buyer has the right to buy, the option seller may be obligated to sell. If the option buyer has the right to sell, the option seller may be obligated to buy. As noted above, the option seller receives the amount of the option price from the option buyer for his willingness to bear this risk. An important distinction we made between forward and futures contracts was that the former are customized private transactions between two parties without a guarantee against losses from default. The latter are standardized contracts that take place on futures exchanges and are guaranteed by the exchange against losses from default. For options, both types of contracts-over-the-counter customized and exchange-listed standardized-exist. In other words, the buyer and seller of an option can arrange their own terms and create an option contract. Alternatively, the buyer and seller can meet directly, or through their brokers, on an options exchange and trade standardized options. In the case of customized options, the buyer is subject to the possibility of the seller defaulting when and if the buyer decides to exercise the option. Because the option buyer is not obligated to do anything beyond paying the original price, the seller of any type of option is not subject to the buyer defaulting. In the case of a standardized option, the buyer does not face the risk of the seller defaulting. The exchange, through its clearinghouse, guarantees the seller’s performance to the buyer.
A variety of other instruments contain options and thus are forms of contingent claims. For instance, many corporations issue convertible bonds offering the holder an option like feature that enables the holder to participate in gains on the market price of the corporation’s stock without having to participate in losses on the stock. Callable bonds are another example of a common financial instrument that contains an option, in this case the option of the issuer to pay off the bond before its maturity. Options themselves are often characterized in terms of standard or fairly basic options and more advanced options, often referred to as exotic options. There are also options that are not even based on assets but rather on futures contracts or other derivatives. A very widely used group of options is based on interest rates.
Another common type of option is contained in asset-backed securities. An asset backed security is a claim on a pool of securities. The pool, which might be mortgages, loans, or bonds, is a portfolio assembled by a financial institution that then sells claims on the portfolio. Often, the borrowers who issued the mortgages, loans, or bonds have the right to pay off their debts early, and many choose to do so when interest rates fall significantly. They then refinance their loans by taking out a new loan at a lower interest rate. This right, called a prepayment feature, is a valuable option owned by the borrower. Holders of asset-backed securities bear the risk associated with prepayment options and hence are sellers of those options. The holders, or option sellers, receive a higher promised yield on their bond investment than they would have received on an otherwise equivalent bond without the option.
With an understanding of derivatives, there are no limits to the types of financial instruments that can be constructed, analyzed, and applied to achieve investment objectives. What you learn from this blog and the CFA Program will help you recognize and understand the variety of derivatives that appear in many forms in the financial world. We have now looked at the basic characteristics of derivative contracts. In order to better understand and appreciate derivatives, we should take a quick look at where they came from and where they are now. Accordingly, we take a brief look at the history and current state of derivative markets.