Introduction
Two of the most commonly used financial instruments that are used extensively in modern financial markets are swaps and options. Both are derivatives, i.e. they derive their values from the value of some other asset.
In this article, we will cover the key differences between swaps and options.
What are Swaps?
A swap is a financial contract between two parties by which both the parties agree to perform an exchange of cash flows based on predetermined terms and conditions. Note that the two parties agree to exchange future cash flows based on a specified notional amount, without exchanging the principal amount.
The ‘notional’ amount here is the specific amount on which the interests will be calculated and exchanged - this amount usually remains fixed throughout the life of the contract. The cash flows can come in the form of interest payments, exchange rate differentials, or other financial variables.
There are various types of swap contracts, including interest rate swaps, currency swaps, commodity swaps, credit default swaps, and equity swaps, among others -
- Interest rate swaps allow one party with a fixed-rate debt instrument to exchange it for a floating-rate debt instrument from another party in the future based on a notional amount.
- Currency swaps involve the exchange of principal amounts in different currencies. They help hedge against potential fluctuations in exchange rates.
- Commodity swaps allow parties to exchange payments based on the price of a specific commodity.
- Credit default swaps involve the transfer of credit risk.
- Equity swaps involve the exchange of cash flows based on the performance of a stock’s price or equity index.
Swaps are often used by players in the financial market (like financial institutions, institutional and retail investors etc.) to manage risks associated with their operations or investments. For example, a company with significant foreign currency exposure may choose to enter into a currency swap to hedge against exchange rate fluctuations.
Read more about What are Swaps
What are Options?
An option is a financial contract that gives the holder of the option the right, but not the obligation, to buy or sell an asset from/to the other party in the contract. If the option gives the right to buy the asset, then it is a call option, while if the option gives the right to sell the asset, it is a put option.
The option to buy or sell the underlying asset can be exercised at a specified price (known as the strike price) within a specified period of time (ending with the expiration date). The one who buys the option pays a premium to the seller of the option. Options are typically used for speculation, hedging, and risk management.
Read more about Option Trading
What are Swaptions?
A swaption is a financial contract that gives the holder the right, but not the obligation, to enter into a swap agreement at a specified future date. In other words, a swaption is an option to enter into a swap, combining the best features of both concepts.
Swaptions are used in financial markets to hedge against potential changes in interest rates. They allow parties to get access to favourable interest rates or protect against adverse interest rate movements. Swaptions can also be used for speculation by parties trying to benefit from anticipated changes in interest rates and premiums.
Difference between Swaps and Options
While both swaps and options are financial derivatives, they have major differences of the following nature -
Obligation vs. right -
In a swap, both parties are obligated to fulfil their cash flow obligations as per the agreed-upon terms. However, in an option, the holder has the right, but not the obligation, to exercise the contract. However, the seller of the option is obligated to fulfil the contract if the buyer chooses to exercise the option.
Trading Platforms:
Swaps are primarily traded over-the-counter or OTC. In contrast, options are traded on public exchanges in a standardised format.
Complexity:
Swaps are generally more complex and may require legal documentation, accounting, and regulatory compliance, which can add to the transaction cost of entering into a swap contract. Options, on the other hand, are relatively simpler and are traded on public exchanges.
Premium:
While buying options require you to pay a premium to the seller of the options, swaps do not involve any premium to be paid upfront.
Examples
Let us now consider an example to illustrate the difference between swaps and options. Suppose Company A has purchased a fixed-rate bond with a 5% interest rate. Company A is concerned about the potential increase in interest rates in the market (which will cause a fall in the price of the bond) and wants to hedge against this risk. Company B, on the other hand, holds a floating-rate bond (which currently gives 5% interest) and is concerned about the potential decrease in interest rates, especially the interest rate that the floating-rate bond tracks (as it will decrease its interest earnings).
Company A and Company B can therefore enter into a swap agreement to exchange their fixed and floating-rate cash flows. Company A agrees to pay Company B a fixed interest rate of 5% per annum, while Company B agrees to pay Company A a floating interest rate based on the prevailing market rate, which is currently 5% per annum.
By entering into the swap, Company A effectively converts its fixed-rate bond into a floating-rate bond, thus neutralising the risk from rising interest rates or falling bond price. Company B, on the other hand, converts its floating-rate bond into a fixed-rate bond, protecting against the risk of falling interest rates.
On the other hand, an option can be used to hedge or speculate on the price of any asset. For example, suppose a publicly listed stock of company A is currently priced at Rs. 100. I can buy a call option for Rs. 10 in the derivatives market at a strike price of Rs. 110 and an expiry date a month from now. If the market price (or spot price) increases from Rs. 100 to Rs. 140 on the day of expiry, then I can buy the stock at Rs. 110 and sell it in the market at Rs. 140. My profit, after deducting the premium paid, would be Rs. 20.
Conclusion
Now that you know about how options are different from swaps, perhaps you also understand that trading options can be a profitable activity. If you are interested in trading in options, try to open Demat account with Angel One, India’s top online platform for trading options and other investments.
