What kinds of derivatives are types of contingent claims?

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 or timeframe 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 specified conditions of the contract. 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 agree to a contract. Trader One sells a contingent claim that stipulates they will pay Trader Two if the stock is trading at $35 or above, after one year. If the stock is trading at less than $35, Trader Two receives nothing.

Trader Two's claim is obviously contingent on the option's stated $35 strike price. Because the financial contract is being agreed to today—and not a year from now—the second trader will pay the first trader for the right to that future claim.

In essence, Trader Two is betting that the price of the underlying stock will be higher than $35 in a year when the contract expires. Trader One is betting that the price will be less than $35 in a year.