Subject 4. Contingent Claims
#cfa #cfa-level-1 #derivatives #los-58-b-c #reading-58-derivative-markets-and-instruments
A
contingent claim is a derivative contract with a payoff dependent on the occurrence of a future event. It can be either exchange-traded or over-the-counter.
- The primary types of contingent claims are options. The payoff of an option is contingent on the occurrence of an event.
In essence, options represent the right, not commitment, to buy or sell. They are created only by selling and buying. For every owner (buyer, option holder) of an option (who has all the rights), there is a seller (option writer) who has all the obligations. The seller receives payment (the premium) for an option from the buyer, and confers rights to the option buyer.
- Other types of contingent claims involve variation of options, often combined with other financial instruments or derivatives.
- Many corporations issue convertible bonds, which are bonds that can be exchanged for the stock of the issuing firm at a pre-agreed time and exchange ratio. The bondholder has an option to participate in gains on the market price of the firm's stock without having to participate in losses on the stock.
- Callable bonds are redeemable by the issuer before the maturity under specific conditions and at a stated price. The issuer has an option to pay off the bonds before maturity.
- Warrants are securities entitling the holder to buy a proportionate amount of stocks at some specified future date at a specified price. They are similar to call options.
- Exotic options are options that are more complex than basic put or call options. Exotic options trade over-the-counter.
- Interest rate options are options whose underlying asset is an interest rate.
- Options on futures are options whose underlying asset is a futures contract. They are all exchange-traded.
- Asset-backed securities are securities that are collateralized by a pool of securities such as mortgages, loans or bonds. Typically borrowers of mortgages, loans or bonds have the prepayment option to pay off their debts early.
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