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Subject 4. Contingent Claims: Options PDF Download

A contingent claim is a derivative contract with a payoff dependent on the occurrence of a future event. It can be either exchange-traded or over-the-counter.

The primary types of contingent claims are options. The payoff of an option is contingent on the occurrence of an event.

Every option is either a call option or a put option. In essence, options represent the right, not commitment, to buy or sell. They are created only by selling and buying. The seller receives payment (the premium) for an option from the buyer, and confers rights to the option buyer.

  • The premium (value) is paid when the option contract is initiated.
  • The price at which the option holder can buy or sell the underlying is called the exercise price or strike price.

There are two fundamental kinds of options:

  • American option. It permits the owner to exercise at any time before or at expiration.
  • European option. The owner can exercise the option only at expiration.

The American option cannot be worth less than the European option, because the owner of the American option also has the right to exercise the option before expiration if he desires. Put it in another way, you can do with an American option anything you can do with a European option, plus you can exercise early. Thus, the American option gives the owner more flexibility.

Note: The terms "European" and "American" are not associated with geographical locations.

Moneyness refers to the potential profit or loss from the immediate exercise of an option. An option may be:

  • In-the-money if its exercise would be profitable for its holder. A call (put) option is in-the-money if the stock price exceeds (is below) the exercise price;
  • Out-of-money if its exercise would be unprofitable for its holder. A call (put) option is out-of-money if the stock price is less (higher) than the exercise price;
  • At-the-money if the value of the underlying is equal to the exercise price. A call or put option is at-the-money if the stock price equals the exercise price.

Intrinsic value is the value of the option if it is exercised immediately.

Option Payoffs

The easiest time to determine an option's value is at expiration. At that point there is no future; only the present matters. An option's value at expiration is called its payoff.

For a European option at expiration:

  • cT = Max(0, ST - X)
  • pT = Max(0, X - ST)

Long call strategy. The worst that can happen is losing the entire premium (value) of the option. Potential profits are theoretically unlimited.

Short call strategy. The best thing that can happen to the seller of a call is never to hear any more about the transaction after collecting the initial premium. Potential losses from selling a call are theoretically unlimited.

Long put strategy. The smaller the stock price (ST), the greater the put option value.

Short put strategy.

Learning Outcome Statements

b. contrast forward commitments with contingent claims;

c. define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics;

d. determine the value at expiration and profit from a long or a short position in a call or put option;

CFA® 2022 Level I Curriculum, Volume 5, Module 45

User Contributed Comments 7

User Comment
6162 two aspects of american options:1)possibility of early exercise and 2)have a value higher than those of the european options
BunnyBaby Types of Contingent Claims
Derivative based (contingent) on the a future event taking place. (if the event takes place then {})

Most common types of contingent claims are options contracts and variations thereof

Seller= receives premium in exchange for obligations
Buyer= receives options to exercise rights by giving the premium

Popular variations of options:

Convertible bonds- can be exchanged for stock in the firm at a pre-agreed time and exchange ratio.

Callable bonds- redeemable before the maturity at a stated price, issuer can pay off bonds prior to maturity

Warrants- holder may buy a proportionate amount of stock at x time and at x price

Exotic= OTC and complex

Interest rate options- underlying asset is an interest rate

Options on futures- underlying asset is a futures contract

Asset-backed securities- collateralized by a pool of securities mrtgages, loans or bonds, borrowers of the loans have prepayment option
tschorsch American options have a value no less than the same european option, this is NOT the same as "have a value higher".
They often would be priced at exactly the same value. also, the possibility of early exercise does not necessarily mean that there is an advantage in doing so.
Almost always (except for calls when there is a cash flow - coupon or dividend), to realize the maximum profit, it is best to just sell the option, as it has some time value remaining.
dexterity right
mpapwa22 Wow...Bunnybaby...nice summary of
johntan1979 Yeah, probably you can start your own site too, called BunnyNotes
Shaan23 What a waste of 10 minutes typing that out...i feel younger now.
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I passed! I did not get a chance to tell you before the exam - but your site was excellent. I will definitely take it next year for Level II.
Tamara Schultz

Tamara Schultz

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