Forward Commitments versus Contingent Claims

Derivatives typically fall into one of two classifications, either forward commitments or contingent claims. The primary difference between the two is around obligations. Forward commitments carry an obligation to transact, whereas contingent claims confer the right to transact, but not the obligation.

Forward Commitments

Forward commitments are contracts entered into between two parties that require both parties to transact in the future at a pre-specified price known as the forward price. The parties and the identity and quantity of the underlying are specified. Also specified are the date of the future transaction (expiration) and the nature of the settlement. The parties have to transact; they are obligated to do so. In the event of non-performance, because of the obligation of the forward contract, a legal remedy is possible to enforce the obligation.

The payoff profiles of forward commitments are linear in nature and move upwards or downwards in direct relation to the price of the underlying asset. Forward commitments include futures contracts and forwards contracts.

Contingent Claims

A contingent claim is a type of option where the payoff profile is dependent on the outcome of the underlying asset. This is not dissimilar to a forward commitment, however with a contingent claim, there is the right to transact but not the obligation. Given that the holder of the contingent claim has the option as to whether to transact or not, contingent claims have become synonymous with the term “option.”

Due to this choice, the payoff profile of an option contract is not linear. Instead, options limit losses in one direction and therefore transform the payoff profile of the underlying asset.

Question

Which statement best describes the key difference between a forward commitment and a contingent claim?

A. A forward commitment allows the holder to choose whether to transact whereas a contingent claim is always enforceable

B. A forward commitment creates an obligation to transact whereas a contingent claim allows for transacting to be optional

C. A forward commitment is enforceable and a party must transact whereas a contingent claim allows the seller to choose whether to enforce the transaction

Solution

The correct answer is B.

A forward commitment creates an obligation between the transacting parties whereas a contingent claim creates the right but not the obligation to transact at a future date.