Practice: Forward Commitment and Contingent Claim Features and Instruments
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DerivativesForward Commitment and Contingent Claim Features and Instruments
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Question 1Exam level
Compared to a forward contract on the same underlying, a futures contract is most likely:
How sure are you?
Correct: A. Futures are exchange-traded, standardized contracts (fixed contract size, expiration, and terms) cleared through a clearinghouse that marks positions to market daily. A forward contract is the customized, OTC, bilateral alternative with no daily settlement and typically no active secondary market.
B. You are describing a forward contract, not a futures contract. Forwards are the customized, privately negotiated, OTC instrument; futures are the standardized, exchange-traded one. Confusing the two by direction is the most common trap on this LOS.
C. A forward commitment (forward, futures, or swap) obligates BOTH parties to perform at a future date. Only options and other contingent claims obligate just one side (the writer), while the holder has the choice to exercise.
Which of the following instruments is most likely classified as a contingent claim rather than a forward commitment?
How sure are you?
Correct: B. A contingent claim's payoff depends on a future event or condition, and only one party (the option holder) has the choice whether to perform; the writer's obligation is contingent on the holder's decision to exercise. Options (calls and puts) are the classic contingent claim. Swaps and forwards are forward commitments: both counterparties are obligated to perform, with no contingency or choice involved.
A. A swap is a series of forward-like exchanges of cash flows; both the fixed-rate payer and the floating-rate payer are obligated to make their payments regardless of how rates move. That symmetric, unconditional obligation is the hallmark of a forward commitment, not a contingent claim.
C. A forward contract, currency or otherwise, obligates both the long and the short to transact at the agreed price at expiration. Neither side has the option to walk away, which is exactly what distinguishes a forward commitment from a contingent claim.
An investor buys a call option with a strike price of $45 for a premium of $3. At expiration, the stock is trading at $52. The investor's profit per share is closest to:
How sure are you?
Correct: B. Payoff to a long call at expiration = MAX(0, S - X) = MAX(0, 52 - 45) = $7. Profit = payoff minus the premium paid = $7 - $3 = $4.
A. $7 is the payoff (the intrinsic value the option is worth at expiration), not the profit. Forgetting to subtract the $3 premium already paid is the single most common error on long-option profit questions.
C. $3 is just the premium paid, not a computed result. It does not correspond to any correct step in the payoff-minus-premium calculation.
An investor sells (writes) a put option with a strike price of $60 and receives a premium of $5. At expiration, the stock is trading at $52. The put writer's profit is closest to:
How sure are you?
Correct: B. Payoff to the put writer at expiration = -MAX(0, X - S) = -MAX(0, 60 - 52) = -$8. Profit = premium received plus payoff = $5 + (-$8) = -$3 (a loss of $3 per share).
A. $5 is only the premium collected up front. It ignores the $8 the writer must pay out because the put finished in the money against them, which is exactly the risk a put writer takes on.
C. $8 is the payoff the writer owes the put holder (60 - 52), stated as a positive number instead of the cash outflow it actually is. It also has not been netted against the $5 premium already collected.
An investor writes a call option with a strike price of $80 and receives a premium of $6. At expiration, the stock is trading at $90. The call writer's profit or loss is closest to:
How sure are you?
Correct: B. Payoff to the call writer at expiration = -MAX(0, S - X) = -MAX(0, 90 - 80) = -$10. Profit = premium received plus payoff = $6 + (-$10) = -$4 (a loss of $4 per share).
A. $6 is only the premium the writer collected up front. It leaves out the $10 the writer owes the call holder because the stock finished well above the strike, which is the whole risk the writer accepted in exchange for that premium.
C. -$10 is the raw payoff owed to the call holder before netting the $6 premium the writer already received. Forgetting to add back the premium overstates the writer's loss.
An investor buys a put option with a strike price of $30 for a premium of $2. At expiration, the stock is trading at $21. The investor's profit is closest to:
How sure are you?
Correct: B. Payoff to a long put at expiration = MAX(0, X - S) = MAX(0, 30 - 21) = $9. Profit = payoff minus the premium paid = $9 - $2 = $7.
A. $9 is the payoff (intrinsic value) at expiration, before subtracting the $2 premium the investor paid to buy the put in the first place.
C. $2 is just the premium paid, not the result of the payoff-minus-premium calculation. It would only be the profit if the payoff itself were $4, which it is not here.
An interest rate swap is most accurately described as:
How sure are you?
Correct: A. A swap is a forward commitment consisting of a series of periodic cash flow exchanges (for an interest rate swap, typically fixed-rate payments exchanged for floating-rate payments on the same notional principal) on a schedule of future dates, equivalent to a portfolio of forward contracts.
B. A single exchange of principal at one future date describes a forward contract, not a swap. A swap's defining feature is the SERIES of periodic exchanges over the life of the contract, not a one-time settlement.
C. A swap is a forward commitment, not a contingent claim: both counterparties are obligated to make every scheduled payment. Neither side has the discretion to walk away the way an option holder can choose not to exercise.
A credit default swap (CDS) is most likely used to:
How sure are you?
Correct: A. A credit default swap is a credit derivative in which the protection buyer makes periodic payments to the protection seller in exchange for a payment if a specified credit event (such as default) occurs on the reference obligation. It transfers credit risk without transferring ownership of the underlying bond or loan.
B. A fixed future exchange rate between two currencies describes a currency forward or currency swap, not a credit derivative. A CDS references credit risk on a bond or loan, not an exchange rate.
C. Locking in a future commodity purchase price describes a commodity forward or futures contract. A CDS has nothing to do with physical commodities; its underlying is the credit risk of a reference entity.
Compared to the holder of a forward commitment, the holder of a long option position has most likely:
How sure are you?
Correct: B. A long option position is a contingent claim: the holder has the RIGHT, not the obligation, to exercise, so the maximum loss is capped at the premium paid while the upside (for a call) or gain as the underlying falls (for a put) is retained. A forward commitment holder has symmetric, uncapped exposure in both directions because both parties must perform.
A. Symmetric exposure to both gains and losses describes the forward commitment holder (long forward, futures, or swap), not the option holder. The option holder's payoff is asymmetric precisely because they can walk away from an unfavorable outcome.
C. An unconditional obligation to transact at expiration describes a forward commitment, the opposite of what an option provides. The option holder chooses whether to exercise; only the option writer has an obligation, and only if the holder exercises.
At expiration, the payoff to the holder of a call option with a strike price of $55 when the underlying stock is trading at $48 is closest to:
How sure are you?
Correct: A. Payoff to a long call at expiration = MAX(0, S - X) = MAX(0, 48 - 55) = MAX(0, -7) = $0. A call holder never has a negative payoff at expiration; when the stock finishes below the strike, the option simply expires worthless and the holder does not exercise.
B. $7 reverses the subtraction (55 - 48 instead of 48 - 55) as though the option were a put, or as though a below-strike stock price still generated a positive call payoff. A call is only worth exercising when the stock is ABOVE the strike.
C. The payoff at expiration is never negative for the option HOLDER (only the premium already paid is at risk, which is a separate, sunk cost from the payoff itself). A holder simply lets an out-of-the-money option expire rather than exercising into a loss.
An investor holds a long forward contract to buy an asset at $80 and, separately, a long call option to buy the same asset at $80, both expiring the same day. Combining the payoff profile of a forward commitment with that of a contingent claim, if the asset's price at expiration is $65, the investor should most likely:
How sure are you?
Correct: B. This is the core distinction between a forward commitment and a contingent claim. The forward OBLIGATES the investor to buy at $80 regardless of the market price at expiration, so with the asset at $65, the investor is forced into a $15-per-unit loss relative to market value. The call option, by contrast, gives the investor the RIGHT, not the obligation, to buy at $80; since the market price ($65) is below the strike, the investor simply lets the option expire worthless rather than exercising into a loss, with the maximum loss on the option limited to the premium already paid (a sunk cost).
A. The call option holder is never FORCED to exercise into an unfavorable outcome; the whole point of an option being a contingent claim is that exercise is the holder's CHOICE, so letting an out-of-the-money call expire worthless (no further payoff-based loss beyond the premium) is exactly the correct, rational action, not a forced additional loss.
C. Forwards and options do not have identical payoff outcomes even on the same underlying asset and strike/price; the whole reason they are classified as different instrument categories (forward commitment vs. contingent claim) is that their payoff profiles are fundamentally different, symmetric and obligatory versus asymmetric and optional.
A corporate treasurer wants to hedge a future foreign-currency receivable and is choosing between a currency forward and a currency option. Combining the cost structure and payoff symmetry of a forward commitment with those of a contingent claim, the treasurer should most likely recognize that:
How sure are you?
Correct: A. A forward contract typically has no upfront premium (it is priced so that its value at initiation is zero) but LOCKS IN a rate, meaning the treasurer gives up the ability to benefit if the currency moves favorably before the receivable is collected, since the forward obligates a fixed exchange rate regardless of the spot rate at expiration. An option requires paying a premium upfront, but as a contingent claim, it preserves the ability to benefit from a favorable currency move (the treasurer would simply not exercise an unfavorable option and instead transact at the better market rate).
B. The two instruments differ fundamentally in both cost structure (no premium vs. an upfront premium) and payoff symmetry (symmetric, obligatory vs. asymmetric, optional); treating the choice as arbitrary ignores exactly the trade-off between the two instrument types this LOS is built to teach.
C. 'Cost' is not straightforwardly comparable this way; a forward's cost is embedded in its locked-in rate and lost upside potential (an opportunity cost), while an option's cost is an explicit premium paid upfront; neither is simply 'more expensive' than the other in every respect, they have different cost and risk profiles entirely.