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Steering through the complex terrain of financial tools demands a sharp grasp of fundamental principles. Unravel the nuances of two distinct yet often misunderstood entities—swaps and options.
For savvy investors and financial enthusiasts alike, understanding the difference between swap and option is more than just an academic exercise. Join us in deciphering the intricacies that set these financial tools apart.
Understanding derivatives
Derivatives include financial contracts whose value is dependent on another asset like a bond, stock, commodity, interest rate, currency, or market index. You can use them to speculate on future price movements, hedge your bets, and access markets that would otherwise be out of reach.
Derivatives like forwards, futures, options, and swaps are part of the vast array of financial instruments shaping our market landscape. Each type has a unique function and has different rules.
What are swaps and options?
Swaps
Two or more parties can enter into a financial contract known as a swap to exchange cash flows according to fixed terms and conditions. Instead of exchanging the principal amount, the two sides agree to swap future cash flows based on a certain notional amount.
The notional amount stays constant throughout the contract and serves as the basis for interest calculations and exchanges. The cash flows might originate from interest payments, differences in exchange rates, or any number of other monetary factors.
Interest rate, currency, commodity, credit default, and equity swaps are a few examples of the many kinds of swap contracts available.
Options
A financial contract known as an option gives the holder the right, but not the obligation, to buy or sell an asset to the other party, as laid out in the contract. Put options convey the right to sell an asset, while call options convey the right to buy.
During a fixed period, starting from the expiration date, the option to buy or sell the underlying asset can be exercised at a set price, called the strike price. The option buyer pays a premium to the seller. Speculation, hedging, and managing risk are the usual applications of options.
Differences between swap and option
| Swaps | Options | |
| Obligation | Obligatory for both parties to fulfil agreed-upon terms | The contract’s exercise is within the Holder’s purview, but not their obligation |
| Trade purpose | Used for managing risk, interest rate adjustments, or accessing specific cash flows | Commonly employed for speculation, hedging, or generating income |
| Risk exposure | Because interest rates and prices are subject to fluctuation, market risk is always there. | Limited to the premium paid, providing a known and fixed risk exposure |
| Complexity | May involve complex calculations, especially for exotic swaps | Generally simpler in structure, easier to understand and execute |
| Common types | Interest rate swaps, currency swaps, commodity swaps, etc. | Call options, put options, warrants, etc. |
Swap and option example
Swap scenario: Firm P holds a fixed-rate bond at 5%, worried about potential interest rate hikes. Firm Q has a floating-rate bond at 5%, concerned about potential interest rate decreases. P and Q opt for a swap. P agrees to pay Q a fixed 5% interest, and Q agrees to pay P a floating rate based on the market (currently 5%). P transforms its fixed-rate bond into a floating one, mitigating the risks of rising rates. To protect itself from possible rate reductions, Q switches from a floating-rate bond to a fixed-rate one.
Option scenario: In the scenario where ABC Co’s stock is valued at ₹100, investor X anticipates a potential price surge. Instead of directly acquiring the stock, investor X opts for a strategic move. They purchase a call option in the derivatives market, paying a premium of ₹10. The chosen strike price for the option is ₹110, and the option expires in one month. As the expiry date arrives, if ABC Co’s stock escalates to ₹140, investor X exercises the call option. It entails buying the stock at the agreed-upon price of ₹110 and promptly selling it in the market at the prevailing price of ₹140. Deducting the initial premium of ₹10, investor X realises a profit of ₹20.
Risks and rewards
Like all other financial instruments, swaps and options carry their own set of risks and rewards.
In a swap, the most significant danger is the default risk, which occurs when one of the parties does not pay their share. However, hedging against unfavourable changes in interest rates, currency exchange rates, or commodity prices is one way in which swaps can offer rewards.
The premium paid for an option runs the risk of turning into a loss if the option is not exercised. The possible payoff, though, is high. An option’s purchaser can profit from changes in the value of the underlying asset without making the same large financial commitment as would be required to purchase the asset outright.
Bottomline
In the realm of finance, instruments such as currency futures, options, and swaps play a pivotal role in managing currency risk and optimising investment strategies. They are more than just financial instruments; they are strategic levers that can steer the course of investment decisions.
FAQs
Forward contracts involve buying or selling an asset at a pre-determined price at a future date. When two parties exchange financial instruments to hedge risk, they make a swap. Options give the right but not the obligation to buy or sell an asset at a set price before a certain date.
Swaps and futures are both financial derivatives, but they work differently. A swap is an agreement between two parties to exchange sequences of cash flows for a set period. On the other hand, a future is a contract to buy or sell an asset at a specified future date at a price agreed upon today.
OTC derivatives, or Over-The-Counter derivatives, are financial contracts that are traded directly between two parties, outside of a regulated exchange. They include swaps, options, forwards, etc. OTC derivatives offer flexibility as they can be customised to fit specific needs, but they also carry a higher risk due to a lack of standardisation and transparency.
Swaps allow companies to manage risk, particularly interest rate and currency risk. By swapping cash flows, companies can benefit from each other’s comparative advantages. Swaps also offer flexibility as they can be customised to meet the specific needs of the parties involved. Lastly, swaps are traded over the counter, allowing for privacy.
ETD in finance stands for Exchange-Traded Derivatives. These are derivatives, such as futures and options, that are traded on a regulated exchange. ETDs provide transparency, liquidity, and accessibility. They are standardised contracts with clear rules, making them less risky compared to Over-The-Counter (OTC) derivatives, which are privately traded.