Forward Commitment and Contingent Claim Features and Instruments

Derivatives. Worth 5 to 8 percent of the exam. One session: the lesson, the rules, the method, then the questions.

DerivativesForward Commitment and Contingent Claim Features and Instruments
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The lesson

There is no video lesson for this unit yet. The rules and the method below carry everything this session needs; watching is a way of hearing it, not the only way of getting it.

The reading

Five to ten minutes on this one unit: what the exam wants, the idea in plain words, then straight into the trap and the practice.

The exam wants you to describe the features of forwards, futures, swaps and options against each other, classify an instrument as a forward commitment or a contingent claim, calculate an option's value and profit at expiration for both buyer and seller, and describe the six factors that move an option's price.

Every derivative instrument in this module sorts into exactly one of two families, and the dividing line is a single question: does the buyer have a choice. A forward commitment obligates both parties to perform regardless of how the market moves; forwards, futures and swaps all belong here, and none of them requires an upfront premium, because their terms are set so that the contract's value is zero to both sides the moment it is signed. A contingent claim gives its buyer a right, not an obligation, with the payoff contingent on a condition the buyer alone decides whether to trigger; options are the defining example, and that asymmetry, a right for the buyer against an obligation for the seller, is exactly why an option requires a premium paid upfront and a forward does not.

A call option's value at expiration is the greater of zero and the underlying price minus the strike price. A put option's value at expiration is the greater of zero and the strike price minus the underlying price. Neither value ever goes negative, because the buyer simply lets a worthless option expire unexercised rather than lose more than the premium already paid. Profit is a different number from value, and confusing the two is the most common error on this module: profit to the buyer equals that expiration value minus the premium originally paid, and profit to the seller equals the premium received minus that same expiration value. A call worth $8 at expiration that cost a $3 premium nets the buyer $5 of profit, not $8.

Four basic option positions carry four distinct risk profiles worth holding side by side. A long call has unlimited upside with loss capped at the premium paid. A short call has profit capped at the premium received but theoretically unlimited loss, the most dangerous of the four positions. A long put profits as the underlying falls, with maximum gain capped at the strike price itself, since the underlying cannot fall below zero. A short put has profit capped at the premium received and maximum loss equal to the strike price minus that premium, large but bounded rather than unlimited.

An option's total price splits into intrinsic value, what exercising it right now would be worth, and time value, everything else, the value of remaining time and uncertainty. Time value is never negative before expiration and reaches exactly zero only at expiration itself. Six factors move that total price, and the exam tests all six independently. A higher stock price raises a call's value and lowers a put's. A higher strike price does the reverse. More time to expiration raises both, since more time means more uncertainty and therefore more optionality. Higher volatility raises both a call's and a put's value together, the one factor candidates most often get backward, since volatility is the raw fuel behind every option's value, not a risk that only hurts one side. A higher risk-free rate raises a call's value and lowers a put's, because it lowers the present value of the strike price paid or received later. Dividends lower a call's value and raise a put's, since the stock price drops on the ex-dividend date.

The trap

An expiration-value question and a profit question ask for two different numbers: a call expiring at $8 with a $3 premium already paid nets the buyer $5 of profit, and choosing the raw $8 expiration value instead of subtracting the premium is the single most repeated error on option payoff questions.

What this unit turns on

Read these before the questions, not after them. Everything here traces to this module's own lesson and to the 2026 outline.

Every derivative instrument is defined by comparing a small number of features against those of a standard forward and a standard option

A forward contract is a customized, OTC obligation for both parties to transact a specific asset at a specific price on a specific future date, settling only at expiration with no upfront payment. A futures contract is the standardized, exchange-traded, centrally cleared version of the same forward obligation, distinguished by daily mark-to-market settlement and margin requirements. A swap is an OTC exchange of a series of cash flows over multiple future dates, economically equivalent to a portfolio of forward contracts, one for each settlement date, and typically requires no upfront payment. A call option gives its buyer the right, not the obligation, to buy the underlying at a stated strike price; a put option gives its buyer the right, not the obligation, to sell at the strike; both require an upfront premium paid by the buyer to the seller.

The single dividing line in this taxonomy is obligation versus choice, and it sorts every instrument into exactly one of two families

A forward commitment obligates both parties to perform regardless of how the market moves; this family includes forwards, futures, and swaps, and it is why none of them requires an upfront premium, the contract terms are set so that its value is zero to both parties at initiation. A contingent claim gives its buyer a right, not an obligation, and the payoff is contingent on a condition (the option finishing in the money) being met; this family consists of options, and it is why the buyer pays an upfront premium for that right, compensating the seller for accepting an obligation the buyer does not share.

The value at expiration and the profit differ by exactly the amount of any premium paid or received

For a call, value at expiration equals the greater of zero and the underlying price minus the strike price; for a put, value at expiration equals the greater of zero and the strike price minus the underlying price. Profit to the option buyer equals that expiration value minus the premium originally paid; profit to the option seller (writer) equals the premium received minus that same expiration value, the mirror image of the buyer's position, since an option is a zero-sum contract between its two counterparties. For a forward or futures position (no premium paid), profit to the long equals the underlying's price at expiration minus the contracted price, and profit to the short is the exact negative of that amount.

The trick

Ask one question first: does the buyer have a choice? Yes means option, no means forward, futures, or swap

This single question resolves the most common classification error on the exam, mistaking a forward's binding obligation for an option's discretionary right, or the reverse.

Only contingent claims require an upfront premium; forward commitments generally do not

A forward, a future, and a swap are each priced so that their value is zero to both sides at initiation, no cash changes hands upfront; an option's premium exists specifically because the seller accepts an obligation the buyer does not share.

Option profit is expiration value minus (or plus) the premium, never the expiration value alone

A call worth $8 at expiration that cost a $3 premium nets a $5 profit to the buyer, not $8; forgetting to net out the premium is a frequent numerical error on payoff questions.

The method

The order to work a question of this type in, every time, before you touch the numbers.

  1. For an instrument-classification question, first ask whether the buyer has a choice to exercise; a choice means a contingent claim (option), no choice means a forward commitment (forward, future, or swap).
  2. For a call payoff question, compute max(0, underlying price - strike); for a put, compute max(0, strike - underlying price).
  3. For a profit question (as opposed to a value question), subtract the premium paid from the buyer's expiration value, or add the premium received to the seller's negative of that value.
  4. For a forward or futures profit question, compute the long's profit as expiration price minus contracted price, and the short's profit as the exact negative of that figure.

Two worked examples, then you are on your own

The first is worked in full. The second gives you the setup and stops. After that the questions give you nothing, which is the point: the help fades on purpose, so the last thing you practise is the thing the exam actually asks of you.

Worked in full

Compared to a forward contract on the same underlying, a futures contract is most likely:

Answer 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.

Your turn, setup given

Which of the following instruments is most likely classified as a contingent claim rather than a forward commitment?

For an instrument-classification question, first ask whether the buyer has a choice to exercise; a choice means a contingent claim (option), no choice means a forward commitment (forward, future, or swap).

The practice run

Pick an answer, say how sure you are, then reveal. Being sure and wrong is the most useful thing that can happen in a session, so answer honestly: it sends the unit back to learning and puts it at the front of your revision queue.

Question 1Exam level

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.

Unit: forward-commitment-and-contingent-claim-features-and-instruments

Question 2Exam level

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.

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Question 3Exam level

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.

Unit: forward-commitment-and-contingent-claim-features-and-instruments

Question 4Exam level

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.

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Question 5Exam level

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.

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Question 6Exam level

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.

Unit: forward-commitment-and-contingent-claim-features-and-instruments

Question 7Exam level

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.

Unit: forward-commitment-and-contingent-claim-features-and-instruments

Question 8Exam level

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.

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Question 9Above the exam

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.

Unit: forward-commitment-and-contingent-claim-features-and-instruments

Question 10Above the exam

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.

Unit: forward-commitment-and-contingent-claim-features-and-instruments