A contingent claim is another term for a derivative with a payout that is dependent on the realization of some uncertain future event. Common types of contingent claim derivatives include options and modified versions of swaps, forward contracts and futures contracts. Any derivative instrument that isn’t a contingent claim is called a forward commitment.
Vanilla swaps, forward and futures are all considered forward commitments. These are relatively rare, making options the most common form of contingent claim derivative.
Rights and Obligations
In a contingent claim, one party to the contract receives the right – not the obligation – to buy or sell an underlying asset from another party. The purchase price is fixed over a specific period of time and will eventually expire.
By creating a right and not an obligation, the contingent claim acts as a form of insurance against counterparty risk.
Options
The payoff for all financial options is contingent on the underlying asset or security reaching a target price or satisfying other conditions. The most common contingent claim transaction is an option traded on an option exchange. In these cases, the contingent claim is standardized to facilitate speed of trade.
For example, suppose a stock is trading at $25. Two traders, John and Smith, agree to a contract whereby John sells a contingent claim that stipulates he will pay Smith if, after one year, the stock is trading at $35 or above. If the stock is trading at less that $35, Smith receives nothing.
Smith’s claim is obviously contingent on the $35 strike price on the option. Because the financial contract is being agreed to today (and not a year from now), Smith has to pay John for the right to that claim.
In essence, Smith is betting that the price will be higher than $35 in a year, and John is betting that the price will be less than $35 in a year.