Difference Between Swap And Option
Derivatives are financial instruments that are aimed at managing risks inherent in any financial investments. The returns that derivatives bring are based on performance of assets underlying. This is why derivatives get their name; the returns are derived from another instrument’s returns. There are many types of derivatives, including forwards and futures, options and swaps. All derivative types have their own distinct qualities and are different from each other. So, naturally, the question of options vs swaps or futures vs forwards comes up in any discussion on derivatives.
Forwards and futures are contracts wherein as a buyer, you are obliged to buy an asset at a prefixed price on a date in the future that is also specified. While forwards are contracts where the commodity underlying and its quantity can be customised, apart from the transaction date. A future is traded on the exchange. A forward is traded over the counter and the agreement can be customised. Futures are settled every day, till the contract ends. On the other hand, forwards are settled once for all at the end of the contract. Before you understand the difference between swap and option, it is important to understand the nature of the two derivatives.
What Is An Option?
If you are wondering what an option is, it is a financial instrument that gives you the right to sell or buy an asset within or towards the end of a specific period. These assets are shares or currency. Call option is the option to buy while the option to sell is called put option. The call option gives the buyer the right not the obligation to buy the underlying asset at the specified strike price. In a put option, the buyer has the right but not obligation to sell the asset underlying. The price at which the option is to be sold or bought is predetermined. The price to be paid to buy the option is called the premium, while the price at which the option has to be exercised is called the strike price.
Also Read, How Options Trading Work?
What Is a Swap?
A swap is a type of derivative wherein cash flow is exchanged between two involved parties. One example is an interest rate swap, where companies swap payments of interest rates between them. A swap is apt when a company wants to get a variable rate of interest while another opts for fixed-rate so as to curb risks. Because the two parties have a set of preferences and needs of their own, the interest rate swap works for them. There is also the currency swap, which is all about swapping the principal and payments of fixed interest for a loan in a certain currency with the principal and payments of fixed interest in another currency.
As an example, consider you need to borrow a certain amount for a fixed period of say, five years, and your plan is to opt for a foreign bank. However, there’s a problem. What if the value of the rupee drops? Your burden of debt shoots up and you will end up paying a huge amount.
Now, imagine you know a foreign businessperson who needs the same amount you need from the foreign bank. She needs it in Indian currency. This provides you with a chance to swap your principals because both are equal, and only vary in currency. You will have to give her an interest rate that prevails in the foreign market while she has to give you the Indian interest rate in our currency. Towards the end of the term, you will exchange principals again. This is called a currency swap.
Similarly, there are commodity swaps as well, where a commodity involves a fixed rate while another has a floating rate.
Read more at What are Swaps in Derivative Market?
Swap Vs Option: What Are The Differences?
- The main options vs swaps difference is that an option is a right to buy/sell an asset on a particular date at a pre-fixed price while a swap is an agreement between two people/parties to exchange cash flows from different financial instruments. The seller or writer of a call option would however have the obligation to sell the asset that’s underlying at a pre-set price if the call option has been exercised. In a swap, both parties are obliged for the cash flow exchange.
- Another swap vs option difference is that options involve the trading of securities in their actuality and not merely the cash flows.
- A key difference between swap and option is that a swap is not traded via the exchanges. A swap is an over-the-counter (OTC) derivative type whereas an option can be either an OTC or exchange-traded derivative. Swaps are contracts that are customised and traded privately between two parties.
- Another difference between swap and option lies in the fact that acquiring an option involves premium payment whereas there is no such payment involved in a swap.
Swaption? What’s That?
Now that you know the swap vs option differences, here’s one more term you would need to remember: a swaption. A swaption is a swap option. It is an option that gives you the right but not the obligation to get into a pre-set swap. The person who holds the swaption would need to make a premium payment to the contract issuer. Essentially, a swaption is an option that lets you enter into a swap contract that is the underlying contract. Swaptions are more like swaps than options, as they are OTC securities like swaps. Swaptions are used by investment banks, financial institutions and hedge funds.
Both swaps and options are derivatives but they come with distinct features. While swaps are traded over the counter options are largely standardised and traded over exchanges but can also be OTC. The other options vs swaps difference is that options give the holder of said option the right but no obligation to sell the asset while swaps are agreed upon by the two parties involved. Yet another difference is that there is no premium payment involved in a swap whereas premium is involved in an options contract.
If you are now keen on putting your knowledge to good use, begin by opening a demat account and trading account with a trusted platform and explore the world of derivatives trading.