A contingent option is a type of derivative that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price or under certain conditions. The seller of the contingent option receives a premium from the buyer for granting this right. The payoff of the contingent option depends on how well the underlying asset performs relative to a benchmark or another asset.
For example, suppose you buy a contingent option on a stock that pays dividends. The option gives you the right to receive $10 per share if the stock price is above $50 at expiration, or nothing otherwise. You pay $5 per share as the premium for this option. If the stock price is above $50 at expiration, you can exercise your option and receive $10 per share from the seller. If the stock price is below $50 at expiration, you can let your option expire worthless and lose only your premium.
Contingent options are useful for hedging against various risks, such as market risk, interest rate risk, currency risk, and credit risk. They can also be used for speculation or arbitrage purposes. Contingent options are different from forward contracts and futures contracts, which are forward commitments that oblige both parties to buy or sell an underlying asset at a fixed price and date in the future.
Basic Theory
A contingent option typically has two possible outcomes: it either pays a predetermined amount if a specified event occurs or nothing if the event does not happen. The contingent nature of the option introduces an element of uncertainty, making it valuable in various financial scenarios, such as insurance contracts, weather derivatives, or event-driven financial products.
Procedures for Modeling Contingent Options in Excel
- Event Identification: Identify the contingent event. This could be anything from a specific market movement to the occurrence of a natural disaster.
- Establish Payoff Structure: Determine the payoff structure associated with the contingent event. Decide on the amount to be paid in case the event occurs and the amount if it does not.
- Create Logical Statements: In Excel, use logical functions like
IForIFERRORto create statements that evaluate the occurrence of the contingent event. These statements will guide Excel on which payoff to consider. - Build the Contingent Option Formula: Combine the logical statements to create a formula that calculates the contingent option’s value based on the identified event.
Explanation
Let’s consider a contingent option linked to the performance of a stock. The contingent event is the stock price surpassing $100 within a given timeframe.
Scenario:
- Stock Price (Current): $95
- Contingent Event Trigger: Stock price surpasses $100
- Payoff if Event Occurs: $500
- No Payoff if Event Doesn’t Occur
Excel Table:
| A | B |
|---|---|
| Stock Price (Current) | $95 |
| Contingent Event | >$100 |
| Payoff if Event Occurs | $500 |
| Contingent Option Value | [Excel Formula] |
Excel Formula:
=IF(A2>$B$2, $C$2, 0)
In this formula:
A2is the reference to the current stock price.$B$2represents the contingent event trigger price.$C$2is the payoff if the event occurs.
Calculation and Result
Considering the stock price is $95, the contingent event hasn’t occurred, so the contingent option value is 0.
Other Approaches
- Using VBA (Visual Basic for Applications): For complex contingent options, creating custom functions using VBA can provide more flexibility and control over the modeling process.
- Monte Carlo Simulation: Simulating multiple possible scenarios using Monte Carlo methods can offer a more comprehensive analysis of contingent options, especially when dealing with dynamic or evolving events.
