Encyclopedia of Financial Models I

Introduction to Contingent Claims Analysis

EDWIN H. NEAVE, PhD

Professor Emeritus, School of Business, Queen’s University, Kingston, Ontario

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

Abstract: Contingent claims are a tool for valuing securities and for analyzing the effects of risky financial decisions. Contingent claims analysis can be used to value any kind of financial instrument, including such apparently exotic instruments as put and call options and convertible securities. Contingent claim analysis defines risky outcomes relative to states of the world, and uses claims to represent and value state outcomes. Thus given a definition of risky states, all financial instruments and arrangements can be represented as combinations of contingent claims on those states. Theoretically complete markets assume claims can be traded on every state of the world, but in practice markets are not likely to be complete at any point in time. Since in practice market incompleteness will inhibit certain risk management strategies, in so doing it also provides incentives to create new instruments that can be used to manage and to value claims on additional states of the world.

Contingent claims analysis is used in financial modeling to value any financial instrument, including such apparently exotic instruments as put and call options and convertible securities. In this entry, we discuss this important tool. We begin by explaining the notion of states of the ...