Futures and Forwards

The difference between an option and a swap

What are the applications of swaps?

Summary What are Options? An option is a right to buy or sell a financial asset on a specific date at a pre-agreed price.

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But this is not an obligation. This amount is not recoverable irrespective of whether the option is exercised or not.

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There are two main forms of options; call option and put option. Call Option This is an option that gives the right to buy a financial asset on a pre-agreed date at a pre-agreed price. There is no obligation to buy the asset on the specific date; thus, the option will be exercised at the discretion of the buyer.

Understanding Financial Derivatives

Company Y decides to exercise the option since this will be beneficial to them. There the difference between an option and a swap no obligation to sell the asset on the specific date; thus, the option will be exercised at the discretion of the seller. An option may be an exchange traded or over the counter instrument. Exchange Traded Instruments Exchange traded financial products are standardized instruments that only trade in organized exchanges in standardized investment sizes.

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They cannot be tailor-made according to the requirements of any two parties Over The Counter Instruments In contrast, over the counter agreements can materialize at the absence of a structured exchange thus can be arranged to fit the requirements of any two parties What are Swaps?

A swap is a derivative through which two parties arrive at an agreement to exchange financial instruments. While the underlying instrument can be any security, cash flows are commonly exchanged in swaps.

Definitions

Swaps are over the counter financial products. The most basic type of a swap is referred to as a plain vanilla swap while there are different types of swaps as mentioned below. Commodity Swaps These are used for commodities such as oil or gold. Here, one commodity will involve a fixed rate whereas the other will involve a floating rate.

The common underlying assets are stocks, bonds, commodities, currencies, interest rates, etc. It is mostly used for hedging purposes insuring against price risk. For example: If you are a farmer producing onions and are concerned about the volatility in the prices of onions, you may enter into a forward contract. The contract will hedge the farmer against the possible decline in prices.

In most commodity swaps, the payment streams will be swapped instead of the principal amounts. Foreign Exchange FX Swaps Here, the parties involved exchange interest and principal amounts on debt denominated in different currencies. The currency exchange should take place in net present value terms present value of future cash flows.

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Figure 1- Interest rate swaps are a widely used type of swaps What is the difference between Options and Swaps? A swap is an agreement between two parties to exchange financial instruments.

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Requirement for a Premium Payment A premium payment should be paid to acquire an option. Swaps do not involve a premium payment.

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Types Call option and put option are the main types of options. Interest rate swaps, FX swaps, and commodity swaps are commonly used swaps.

Updated Jul 29, Derivatives vs. Options are available for many investments including equities, currencies, and commodities. Typical underlying securities for derivatives include bonds, interest rates, commodities, market indexes, currencies, and stocks. Derivatives have a price and expiration date or settlement date that can be in the future.

The difference between options and swaps can be categorized according to their usage and structure since they are different to one another in a number of ways. References: 1. Cohan, Peter. AOL, 14 July Image Courtesy: 1.