Introduction to Forward Commitment and Contingent Claim Derivatives | CFA Level I Derivatives

In this lesson, we will introduce the major types of derivatives and learn the distinction between forward commitment and contingent claim derivatives. We will also discuss forwards, futures, and swaps.

Classifying Derivatives: Forward Commitment vs. Contingent Claim

Derivatives can be classified based on the nature of the contract:

• Forward commitment derivatives: Futures, forwards, and swaps
• Contingent claim derivatives: Options and credit derivatives

A forward commitment is a contract where parties are obliged to perform a specific action at a future date. A contingent claim consists of a payoff claimable by the contract buyer if a particular event happens before the contract expires.

Forward Commitment Derivatives: Forwards, Futures, and Swaps

Forwards

Forwards are over-the-counter contracts negotiated between two parties. The long commits to buy the underlying at the forward price, while the short commits to sell the underlying on the settlement date. Forwards expose both parties to counterparty risk and tend to be less regulated.

Payoff profile: A graph plotting the spot price at settlement (X-axis) and profit or payoff (Y-axis) helps visualize the gain or loss for either party based on the spot price at the settlement date. As spot price increases above the forward price, the profit to the long and loss to the short increase linearly. Conversely, as the spot price decreases below the forward price, the loss to the long increases, and the profit to the short increases.

Futures

Futures are exchange-traded forward contracts with standardized contract sizes and terms. The clearinghouse enforces margin requirements on both the long and the short to reduce counterparty risk.

Settlement price: The closing price for a futures contract at the end of the trading day, calculated as an average of the prices of trades during the closing period.

Margin requirements: Initial margin, maintenance margin, and margin calls are mechanisms used to guarantee that all parties will honor their obligations.

Price limits and circuit breakers: Exchanges may impose daily price limits and trading halts to prevent price manipulation and excessive volatility.

Swaps

Swaps are over-the-counter, forward commitment derivatives similar to forwards. They can be viewed as a series of forwards where two parties agree to exchange a series of payments on periodic settlement dates over a certain time period. On each settlement date, the two payments are netted, and only one payment is made.

Interest rate swaps: Commonly used by companies to convert fixed-rate liabilities to floating-rate liabilities or vice versa.

Other common types of swaps include currency swaps and equity swaps, which will be introduced at level 2.

Understanding Contingent Claim Derivatives

In this section, we’ll explore contingent claim derivatives, such as options and credit derivatives. Unlike forward commitment derivatives, contingent claim derivatives offer the buyer the right, but not the obligation, to buy or sell the underlying asset at a specified price.

Call and Put Options: Know the Difference

Options come in two main types: call options and put options. Here’s a quick rundown of the differences:

• Call Option: Gives the buyer (long call) the right to buy the underlying asset at a specified price (strike price) within a certain time period. The buyer pays a premium for this right, making them the long call, while the seller is the short call.
• Put Option: Gives the buyer (long put) the right to sell the underlying asset at a specified price (strike price) within a certain time period. The buyer pays a premium for this right, making them the long put, while the seller is the short put.

Remember, the option buyer is purchasing the derivative, not the underlying asset itself.

American and European Options

Options can be classified as American-style or European-style:

• American options can be exercised at any time up to and including the contract’s expiration date. (A for “Any time”)
• European options can only be exercised on the contract’s expiration date. (E for “Expiration date”)

European Call and Put Options Payoff Profiles

Let’s dive deeper into European call and put options:

European Call Option Payoff: The long call’s payoff is the difference between the spot price and the exercise price at expiration, or zero if the spot price is below the exercise price.

European Put Option Payoff: The long put’s payoff is the difference between the exercise price and the spot price at expiration, or zero if the spot price is above the exercise price.

Credit Derivatives

Credit derivatives, like options, are contingent claim derivatives. The most common type is the credit default swap (CDS), which functions like insurance to protect bondholders from the risk of default. The bondholder pays regular premiums to a credit protection seller, who, in turn, compensates the buyer for financial losses if a credit event occurs.

Conclusion

That’s it for our two-part guide on forward commitment and contingent claim features and instruments! Now you should have a solid understanding of the various classes of derivatives and the differences between forward commitment and contingent claim derivatives. In the next lesson, we’ll explore the benefits and risks of derivatives.