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In
finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of f ...
, a contingent claim is a
derivative In mathematics, the derivative of a function of a real variable measures the sensitivity to change of the function value (output value) with respect to a change in its argument (input value). Derivatives are a fundamental tool of calculus. ...
whose future payoff depends on the value of another “
underlying In finance, a derivative is a contract that ''derives'' its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying". Derivatives can be use ...
” asset,Dale F. Gray,
Robert C. Merton Robert Cox Merton (born July 31, 1944) is an American economist, Nobel Memorial Prize in Economic Sciences laureate, and professor at the MIT Sloan School of Management, known for his pioneering contributions to continuous-time finance, especia ...
and
Zvi Bodie Zvi Bodie (born April 27, 1943) is an American economist, author and professor. He was the Norman and Adele Barron Professor of Management at Boston University, teaching finance at Questrom for 43 years before retiring in 2015. His textbook, ''I ...
. (2007). Contingent Claims Approach to Measuring and Managing Sovereign Credit Risk. ''Journal of Investment Management'', Vol. 5, No. 4, (2007), pp. 5–28
M. J. Brennan (1979). The Pricing of Contingent Claims in Discrete Time Models. ''The Journal of Finance''. Vol. 34, No. 1 (Mar., 1979), pp. 53-68 or more generally, that is dependent on the realization of some uncertain future event.Sean Ross
What kinds of derivatives are types of contingent claims?
Investopedia Investopedia is a financial media website headquartered in New York City. Founded in 1999, Investopedia provides investment dictionaries, advice, reviews, ratings, and comparisons of financial products such as securities accounts. Investopedia h ...
These are so named, since there is only a payoff under certain contingencies."Approaches to valuation", Ch2. in
Aswath Damodaran Aswath Damodaran (born 24 September 1957), is a Professor of Finance at the Stern School of Business at New York University (Kerschner Family Chair in Finance Education), where he teaches corporate finance and equity valuation. Background Kn ...
(2012). ''Investment Valuation: Tools and Techniques for Determining the Value of any Asset''. John Wiley & Sons.
Any derivative instrument that is not a contingent claim is called a forward commitment. The prototypical contingent claim is an option, the right to buy or sell the underlying asset at a specified exercise price by a certain expiration date; whereas (
vanilla Vanilla is a spice derived from orchids of the genus '' Vanilla'', primarily obtained from pods of the Mexican species, flat-leaved vanilla ('' V. planifolia''). Pollination is required to make the plants produce the fruit from whic ...
) swaps, forwards, and
futures Futures may mean: Finance *Futures contract, a tradable financial derivatives contract *Futures exchange, a financial market where futures contracts are traded * ''Futures'' (magazine), an American finance magazine Music * ''Futures'' (album), a ...
are forward commitments, since these grant no such optionality. Contingent claims are applied under
financial economics Financial economics, also known as finance, is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear on ''both sides'' of a trade". William F. Sharpe"Financia ...
in developing models and theory, and in
corporate finance Corporate finance is the area of finance that deals with the sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to all ...
as a valuation framework. This approach originates with
Robert C. Merton Robert Cox Merton (born July 31, 1944) is an American economist, Nobel Memorial Prize in Economic Sciences laureate, and professor at the MIT Sloan School of Management, known for his pioneering contributions to continuous-time finance, especia ...
, decomposing the value of a corporate into a set of options in his "
Merton model The Merton model, developed by Robert C. Merton in 1974, is a widely used credit risk model. Analysts and investors utilize the Merton model to understand how capable a company is at meeting financial obligations, servicing its debt, and weighing ...
" of credit risk.


Financial economics

In
financial economics Financial economics, also known as finance, is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear on ''both sides'' of a trade". William F. Sharpe"Financia ...
contingent claim analysis is widely used as a framework both for developing pricing models, and for extending the theory. Thus, from its origins in option pricing and the valuation of corporate liabilities, it has become a major approach to intertemporal equilibrium under uncertainty. Simon Babbs and Michael Selby (1992)
Contingent Claims Analysis
in The New Paigrave Dictionary of Money and Finance, eds J Eatwell, M Milgate and P Newman, Macmillan (1992), pp 437-440
This framework is therefore “broader than ‘option pricing’ because it encompasses the full gamut of valuation approaches directed toward the pricing of contingent claims.” This would include "the full range of models designed to price government, corporate, and
mortgage-backed securities A mortgage-backed security (MBS) is a type of asset-backed security (an 'instrument') which is secured by a mortgage or collection of mortgages. The mortgages are aggregated and sold to a group of individuals (a government agency or investment ba ...
... as well as options and futures on
fixed income securities Fixed income refers to any type of investment under which the borrower or issuer is obliged to make payments of a fixed amount on a fixed schedule. For example, the borrower may have to pay interest at a fixed rate once a year and repay the pr ...
." David F. Babbel and Craig R. Merrill (1996). Valuation of Interest-Sensitive Financial Instruments (SOA Monograph M-FI96-1). Wiley. The general approach here is to define risky outcomes relative to states of the world, and to then use claims to represent and value state outcomes. Thus given a definition of risky states, all financial instruments and arrangements can be represented as combinations of contingent claims on those states. Edwin H. Neave and
Frank J. Fabozzi Frank J. Fabozzi is an American economist, educator, writer, and investor, currently Professor of Practice at The Johns Hopkins University Carey Business School and a Member of Edhec Risk Institute. He was previously a Professor of Finance at EDH ...
(2012). Introduction to Contingent Claims Analysis, in Encyclopedia of Financial Models, Frank Fabozzi ed. Wiley (2012)
Mark Rubinstein Mark Edward Rubinstein (June 8, 1944 – May 9, 2019) was a leading financial economist and financial engineer. He was ''Paul Stephens Professor of Applied Investment Analysis'' at the Haas School of Business of the University of California, Be ...
. (2005). "Great Moments in Financial Economics: IV. The Fundamental Theorem (Part I)", ''
Journal of Investment Management ''The Journal of Investment Management (JOIM)'' is a quarterly refereed journal which seeks to be a nexus of theory and practice of investment management. ''The Journal of Investment Management'' offers in-depth research with practical significa ...
'', Vol. 3, No. 4, Fourth Quarter 2005; ~ (2006). Part II, Vol. 4, No. 1, First Quarter 2006.
See
Arrow-Debreu security In financial economics, a state-price security, also called an Arrow–Debreu security (from its origins in the Arrow–Debreu model), a pure security, or a primitive security is a contract that agrees to pay one unit of a numeraire (a currency or ...
,
Risk-neutral measure In mathematical finance, a risk-neutral measure (also called an equilibrium measure, or '' equivalent martingale measure'') is a probability measure such that each share price is exactly equal to the discounted expectation of the share price u ...
, .


Corporate finance

A recent development in
corporate finance Corporate finance is the area of finance that deals with the sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to all ...
,David T. Larrabee, Jason A. Voss (2012). ''Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options''. John Wiley & Sons, 2012. is “the acceptance, at least in some cases, that the value of an asset may be greater than the present value of expected cash flows, if the cash flows are contingent on the occurrence or non-occurrence of an event”. This contingent claim valuation, uses option pricing models to measure the value of assets that share option-like characteristics. While these models were initially used to value traded options, there has been an attempt in recent years to extend the reach of these models into more traditional valuation. The fundamental premise here, is that “discounted cash flow models tend to understate the value of assets that provide payoffs that are contingent on the occurrence of an event." See
Real options valuation Real options valuation, also often termed real options analysis,Adam Borison (Stanford University)''Real Options Analysis: Where are the Emperor's Clothes?'' (ROV or ROA) applies option valuation techniques to capital budgeting decisions.Campbe ...
generally, and § Applicability of standard techniques there. (One major modification here is that these models often rely on a
replicating portfolio In mathematical finance, a replicating portfolio for a given asset or series of cash flows is a portfolio of assets with the same properties (especially cash flows). This is meant in two distinct senses: static replication, where the portfolio has ...
as opposed to traditional risk neutral pricing.) Typical corporate finance "project" valuations would include
patents A patent is a type of intellectual property that gives its owner the legal right to exclude others from making, using, or selling an invention for a limited period of time in exchange for publishing an enabling disclosure of the invention."A ...
, undeveloped natural resource reserves, and
contingent value rights In corporate finance, Contingent Value Rights (CVR) are rights granted by an acquirer to a company’s shareholders, facilitating the transaction where some uncertainty is inherent. CVRs may be separately tradeable securities; they are occasiona ...
– all of these exhibiting optionality. See . Funding dependent, corporate specific financial investments and special purpose entities also often inhere optionality and must be modeled correspondingly. Contingent claim valuation is also used here to value specific
balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business ...
assets In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can ...
and liabilities which similarly exhibit option like characteristics.Kenneth D. Garbade (2001). ''Pricing Corporate Securities as Contingent Claims.''
MIT Press The MIT Press is a university press affiliated with the Massachusetts Institute of Technology (MIT) in Cambridge, Massachusetts (United States). It was established in 1962. History The MIT Press traces its origins back to 1926 when MIT publ ...
.
Examples are
employee stock option Employee stock options (ESO) is a label that refers to compensation contracts between an employer and an employee that carries some characteristics of financial options. Employee stock options are commonly viewed as an internal agreement prov ...
s,
warrants Warrant may refer to: * Warrant (law), a form of specific authorization ** Arrest warrant, authorizing the arrest and detention of an individual ** Search warrant, a court order issued that authorizes law enforcement to conduct a search for eviden ...
and other convertible securities, and
investment Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance, the purpose of investing is ...
s with
embedded option An embedded option is a component of a financial bond or other security, which provides the bondholder or the issuer the right to take some action against the other party. There are several types of options that can be embedded into a bond; common ...
s such as
callable bond A callable bond (also called redeemable bond) is a type of bond (debt security) that allows the issuer of the bond to retain the privilege of redeeming the bond at some point before the bond reaches its date of maturity. In other words, on the call ...
s or
contingent convertible bond A contingent convertible bond (CoCo), also known as an enhanced capital note (ECN) is a fixed-income instrument that is convertible into equity if a pre-specified trigger event occurs. The concept of CoCo has been particularly discussed in the con ...
s.


References

{{Reflist, 30em Derivatives (finance)