Difference Between Swap And Option

Last Updated: 10 Jan 2025

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 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.

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.

Swap Vs Option: What Are The Differences?

Swap	Option
Agreement between two people or parties to swap cash flows from various financial instruments	Right to buy/sell an asset on a particular date at a pre-decided rate
Based only on the cash flows mentioned in exchange contracts.	Securities can be traded on their actual price
Not traded by exchanges but by over-the-counter derivative	Needs a premium payment to be exchanged that is not valid for swap.

Example of Swap and Option

Below are examples that explain the difference between swap and options and their application.

1.Swap Example

Two companies, Company A and Company B, enter into an interest rate swap agreement. Company A has a loan with a variable interest rate, while Company B has a loan with a fixed interest rate. They agree to swap their interest payment obligations. This means Company A will pay Company B’s fixed interest rate, and Company B will pay Company A’s variable interest rate. This swap can help both companies manage their exposure to interest rate fluctuations.

2.Option Example

An investor, Jane, believes the stock price of Company Y will rise. She buys a call option giving her the right, but not the obligation, to purchase 100 shares of Company Y at a strike price of ₹200 per share within the next three months. If the stock price rises to ₹250 per share, Jane can exercise her option, buy the shares at ₹200, and potentially sell them at the higher market price of ₹250, thereby making a profit.

These examples illustrate the practical applications and benefits of swap vs options in financial markets.

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.

Risk Associated with Swaps and Options

Investing in swaption comes with its own set of threats. These could be market volatility, miscalculation of projected profits, or just a mere market crash. Here is how both swap options could be a potential risk:-

Risk Associated With Swaps

1.Interest Rate Threat

Swaps are susceptible to oscillations in interest rates, indeed, though they’re constantly employed to manage interest rate pitfalls. One party may witness adverse cash inflow exchanges if market interest rates change in a way that is not prognosticated.

2.Counterparty Threat

Since barters are generally private contracts, the other party may sustain fiscal losses if one party defaults on its liabilities (similar to paying cash inflow payments).

3.Market threat

When using barters, cash overflows are changed depending on the state of the market. The value of the shifted cash overflows may not be as salutary as the first study if the market moves in unexpected directions.

4.Liquidity Threat

Barters are customised agreements as opposed to options, which are tradable in commerce.

Risk Associated With Options

1.Price Change Threat – Options are extremely susceptible to shifts in the onset asset’s cost. The premium spent may be lost if the asset’s price shifts negatively and the option expires empty.

2.Time Decay Risk – Since options have expiry dates, their value declines as the date comes. The option loses value if the anticipated price change does not materialise before it expires.

3.Volatility threat – Variability in the market has an influence on the price of options. Options’ values can change snappily and aimlessly in an extremely unpredictable market, which could affect losses.

4.Threat of Premium Loss – An option purchase implicates the direct payment of a premium. The amount is lost if the projected cost change isn’t realised.

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.

Frequently Asked Questions

Q1. Can swaps and options be used for speculation purposes? (30 - 40 Words)

Yes, swaption can be used for speculation. It allows traders to profit from anticipated price movements without owning the underlying asset, leveraging market volatility to make potential gains.

Q2. Are swaps and options only used by large corporations and institutional investors? (20-30 Words)

No, the swap option is also utilized by individual investors, retail traders, and small to medium-sized enterprises.

Q3. How are swaps and options traded in the market? (20-30 Words)

Simply putting the difference between swap and options trading as – Swaps are traded over-the-counter (OTC), while options are traded on public exchanges, offering different levels of accessibility and regulation.

Q4. What are the types of swap?

Swap options include interest rate swaps, currency swaps, commodity swaps, credit default swaps, and equity swaps, each serving specific financial strategies and market needs.

Q5. How to calculate swaps?

Swaptions are calculated by determining net cash flows, considering factors such as interest rates or currency exchange rates. This helps to ensure that there is accurate financial management and risk assessment.