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.