Forward Commitments vs. Contingent Claims

Derivatives typically fall into two classes: forward commitments or contingent claims. The primary difference between the two is based on rights and 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 derivative contracts between two parties that require both parties to transact in the future at a pre-specified price. The parties are obligated to transact, and a legal remedy may be enforced in the event of non-performance. The payoff profiles of forward commitments are linear. That is, the payoff moves upwards or downwards in direct relation to the underlying asset’s price. In other words, the payoff of forward commitments is a linear function of the underlying price. Forward commitments include forward contracts, futures contracts, and swaps.

Contingent Claims

A contingent claim is a type of derivative where the payoff profile is dependent on the outcome of the underlying asset or conditional on the occurrence of some events.  With a contingent claim, there is the right to transact but not the obligation. As such, contingent claims have become synonymous with the term “option.” The payoff profile of a contingent claim is non-linear. That is, the payoff of an option is asymmetric (limits losses in one direction). Contingent claims include options, credit derivatives, and asset-backed securities.

Question

Which statement best describes the key difference between a forward commitment and a contingent claim? A. A forward commitment creates an obligation to transact, whereas a contingent claim allows a transaction to be optional. B. A forward commitment allows the holder to choose whether to transact, whereas a contingent claim is always enforceable. 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 A. 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.