What are contingent claims?

A contingent claim is a financial thing whose value depends on what happens with other things. Those other things could be assets a person or company owns that have value, like stocks, bonds, gold, or real estate. Or, the value of a contingent claim could be tied to an index, which tracks and measures how a particular market or part of the economy is doing.

Financial contracts and derivatives

One common type of contingent claim is a financial contract or asset called a derivative. Derivatives get their value from an underlying asset or index. Some examples of derivatives include:

• Stock options, which give you the right to buy or sell a stock at a certain price by a certain date
• Commodity futures, which are agreements to buy or sell things like oil, gold, or wheat at a set price on a future date
• Interest rate swaps, where two parties agree to exchange one stream of interest payments for another based on a set amount of money

The value of a derivative goes up and down along with the price of the underlying asset or index. But you don’t own the underlying asset itself. Derivatives are a way to speculate on or hedge against the future price moves of an asset without having to buy or sell the actual asset.

Contingent bankruptcy claims

In bankruptcy, a contingent claim takes on a different meaning. In a bankruptcy case, it’s a potential debt that depends on future events.

For example, say a company has been sued by a customer who got injured by one of its products. If the company declares bankruptcy while this lawsuit is still ongoing, the customer’s potential award from the lawsuit would be considered a contingent claim.

If it turns out the company does owe the customer money, then the contingent claim becomes an actual debt that the company has to pay as part of the bankruptcy process. But if the company wins the lawsuit, then the contingent claim goes away.

How do contingent claims work?

The value of a contingent claim is based on complex mathematical formulas. These formulas consider things like the current price of the underlying asset, expectations about how the price will change in the future, the amount of time until the contract expires, and the level of risk.

Black-Scholes model

One well-known mathematical model used to figure out the theoretical value of some types of derivatives is the Black-Scholes model. This model uses the current stock price, the option’s strike price, the time till the option expires, the risk-free interest rate, and the volatility of the stock to estimate what an option should be worth.

While the math is complex, the basic idea behind the model is that the value of a call option (the right to buy a stock at a set price) goes up if the underlying stock price goes up, if there’s more time left on the option, if interest rates are high, or if the stock price is more volatile.

The role of probability and risk

In general, figuring out what contingent claims are worth involves making guesses about the probability of different outcomes. The more likely something is to happen, the more it will affect the value of a contingent claim tied to that event.

Risk is another key factor. The value of a derivative is often very sensitive to changes in the underlying asset’s price. This means derivatives can be quite risky – you might make a lot of money, but you could also lose a lot if the market moves against you.

This is why many derivatives are used for hedging. Hedging is a way for a company or investor to reduce risk. For example, an oil company might use derivatives to lock in a certain price for its oil in the future. That way, if oil prices fall, the company’s profits are protected.

Importance of contingent claims

Contingent claims are a huge part of the global financial system. They allow investors and companies to manage risk, speculate on future price moves, and make money off of changes in financial markets.

Derivatives market

The derivatives market is massive. The total value of all outstanding derivatives contracts is in the trillions of dollars – larger than the world’s total GDP. Every day, huge amounts of derivatives are traded on exchanges like the Chicago Mercantile Exchange or the New York Mercantile Exchange.

Many of the world’s largest banks and financial institutions are heavily involved in the derivatives market, both as buyers and sellers of these contracts. They use derivatives to manage their own risks, to make money for themselves, and to create derivative products to sell to their clients.

Risks and regulation

However, the size and complexity of the derivatives market also makes it a source of risk to the broader financial system. In the financial crisis of 2007-2008, the blow-up of some complex derivatives tied to the housing market helped contribute to huge losses and the near collapse of the global financial system.

Since then, there have been efforts to regulate the derivatives market better and make it more transparent. In the US, the Dodd-Frank Act included provisions to move more derivatives onto exchanges, require central clearing of most derivatives contracts, and impose higher capital and margin requirements on derivatives traders.

In Europe, the European Market Infrastructure Regulation (EMIR) has similar goals of reducing risk and increasing transparency in the derivatives market. However, regulating such a massive and complex market remains an ongoing challenge for governments and financial regulators around the world.