Forward Commitment and Contingent Claim Features and Instruments
Refresher reading access
Introduction
An earlier lesson established a derivative as a financial instrument that derives its performance from an underlying asset, index, or other financial variable, such as equity price volatility. Primary derivative types include a firm commitment in which a predetermined amount is agreed to be exchanged between counterparties at settlement and a contingent claim in which one of the counterparties determines whether and when the trade will settle. The following lessons define and compare the basic features of forward commitments and contingent claims and explain how to calculate their values at maturity.
Learning Outcomes
The member should be able to:
- define forward contracts, futures contracts, swaps, options (calls and puts), and credit derivatives and compare their basic characteristics;
- determine the value at expiration and profit from a long or a short position in a call or put option; and
- contrast forward commitments with contingent claims.
Summary
- Forwards, futures, and swaps represent firm commitments, or derivative contracts that require counterparties to exchange an underlying in the future based on an agreed-on price.
- Forwards are a flexible over-the-counter (OTC) derivative instrument, whereas futures are standardized and traded on an exchange with a daily settlement of contract gains and losses.
- Swap contracts are a firm commitment to exchange a series of cash flows in the future. Interest rate swaps are the most common type and involve the exchange of fixed interest payments for floating interest payments.
- Option contracts are contingent claims in which one of the counterparties determines whether and when a trade will settle. The option buyer pays a premium to the seller for the right to transact the underlying in the future at an agreed-upon exercise price.
- Credit default swap (CDS) contracts allow an investor to manage the risk of loss from issuer default separately from a cash bond.
- Market participants often create similar exposures to an underlying using firm commitments and contingent claims, although these derivative instrument types involve different payoff and profit profiles.
1 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.