Difference Between Swap And Option

Derivatives are financial instruments that are aimed at managing risks inherent in any financial investment. The returns that derivatives allow investors to earn are based on the performance of the underlying assets that can be stocks, commodities, currencies etc. There are many types of derivatives, including forwards, futures, options and swaps. All derivative types have their own distinct qualities and are different from each other. Since you will be putting up a high capital amount to invest in derivatives, it is vital to understand the difference between various derivative contracts. We have already answered the question related to futures vs forwards in our previous blog. This blog will provide knowledge about Options vs Swaps.

What Is An Option?

An options contract is a financial instrument that gives you the right but not the obligation to sell or buy an asset within or towards the end of a specific period. These assets can be shares of a company or currency. There are two types of options contracts: Call Option and Put Option.

The call option gives the buyer the right but not the obligation to buy the underlying asset at the specified strike price (predetermined price). In a put option, the buyer has the right but not obligation to sell the underlying asset at the strike price. 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.

What Is a Swap?

A swap is a type of derivative wherein two parties agree to exchange cash flow or liabilities; hence, the name swaps. A swap is apt when a company wants to get a variable interest rate while another opts for a fixed interest rate to curb risks. This is done through a type of swap called the Interest rate swap, where companies swap payments of interest rates between them. Another type of swap is the currency swap, which allows the parties to swap 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.

For a better understanding of swaps, consider the following example of a currency swap:

Suppose you need to borrow a certain amount for a fixed period of five years, and your plan is to opt for a foreign bank. However, what if the value of the rupee drops? Your burden of debt will shoot up and you will end up paying a huge amount over the principal amount.
Now, imagine you know a foreign businessperson who needs the same amount you need from the foreign bank, but in Indian currency. This provides you with a chance to swap your principles because both are equal, and only vary in currency. You will have to give the other party an interest rate in the foreign currency while receiving the interest rate in Indian currency. Towards the end of the term, you will exchange principles again.

Similarly, there are commodity swaps as well, where a commodity involves a fixed rate while another has a floating rate.

Swap Vs Option: What Are The Differences?

  • The primary 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 is 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 as per their actual value and not merely the cash flows as in swap contracts.
  • 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 that is customised and traded privately between two parties whereas an option can be either an OTC or exchange-traded derivative.
  • Acquiring an option involves premium payment whereas there is no such payment involved in a swap.

What is Swaption?

Now that you know the swap vs option differences, here’s one more term you would need to remember: a Swaption. This is a swap option that gives you the right but not the obligation to get into a pre-set swap. The person who holds the swaption is required to make a premium payment to the contract issuer. Swaptions are used by investment banks, financial institutions and hedge funds.

Conclusion

Both swaps and options are derivatives but they come with distinct features. While swaps are traded over-the-counter, options contracts are largely standardised and traded over exchanges with the alternative of trading OTC. Furthermore, options contracts give the holder the right but not the obligation to sell the underlying asset while swaps are agreed upon by the two parties involved. There is no premium payment involved in a swap whereas premium is involved in an options contract. If you wish to put 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.

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