Financial Economics

10

CONTINGENT CLAIMS AND CONTINGENT STRATEGIES

This chapter introduces the concepts of contingent claims and contingent strategies. Both are tools for analyzing and valuing the effects of risky financial decisions, and both are used extensively in the rest of the book. Indeed, we later show how contingent claims can be used to value any financial instrument, including such apparently exotic instruments as put and call options and convertible securities. We also provide further examples of how contingent strategies can be used to improve payoffs from risky decision making, as well as how they can be interpreted as ways of valuing real options.

We begin by explaining the notion of states of the world, a way of classifying risky outcomes whose value can then be represented using contingent claims. After providing examples of valuation using contingent claims, we introduce the concept of incomplete markets, and consider its importance for explaining real-world financial arrangements. We then examine some financial instruments and arrangements that can be used to trade or to manage risks. We also show how contingent claims analysis provides an alternative way to establish the Modigliani-Miller theorem about capital structure explained in Chapter 5. Finally, we discuss using contingent strategies: how decisions can differ in different states of the world, and how payoffs may be improved by making decisions that are contingent on the currently prevailing state of the world.

10.1 STATES ...