What is the difference between swaps and options

The easiest way to think about swaps and swaptions is that a swap is an immediate trade, while a swaption is the right to enter a trade at some point in the future. There are many types of swaps and swaptions conducted through contracts on the swaps market.

The following are the most common:. Interest Rate Swaps. Interest rate swaps are the most common types of swaps. In these swaps, legs exchanged are interest rate obligations on a financial instrument such as a bond, for example based on a notional principal amount. The principal amount is not traded—just the interest rate payments. Interest rate swaps are commonly used to hedge exposure to floating rate debt, i.

Currency Swaps. In currency swaps, parties exchange interest and principal payments on debt denominated in different currencies, therefore hedging on a change in the value of the currency, not the interest rate itself. Commodity Swaps. In commodity swaps, parties exchange for a floating commodity price, such as in the trade of crude oil. Debt-Equity Swaps. Your burden of debt shoots up and you will end up paying a huge amount. Now, imagine you know a foreign businessperson who needs the same amount you need from the foreign bank.

She needs it in Indian currency. This provides you with a chance to swap your principals because both are equal, and only vary in currency. You will have to give her an interest rate that prevails in the foreign market while she has to give you the Indian interest rate in our currency. Towards the end of the term, you will exchange principals again. This is called a currency swap. Similarly, there are commodity swaps as well, where a commodity involves a fixed rate while another has a floating rate.

Read more at What are Swaps in Derivative Market? A swaption is a swap option. It is an option that gives you the right but not the obligation to get into a pre-set swap. The person who holds the swaption would need to make a premium payment to the contract issuer.

Essentially, a swaption is an option that lets you enter into a swap contract that is the underlying contract. Swaptions are more like swaps than options, as they are OTC securities like swaps.

Swaptions are used by investment banks, financial institutions and hedge funds. Both swaps and options are derivatives but they come with distinct features. A floor option works similar to a cap option, because the exchange of cash flows only takes place when a condition is met.

The only difference is that a cash flow now only takes place when the spot price drops below the floor price. A collar option is a combination of both a cap and floor option. It sets a maximum and a minimum price. When the spot price remains between these two prices, the commodity will be bought for the current market price. Should the spot price rise or drop outside these boundaries, an exchange of cash flows will occur. A swaption is a combination of a regular swap and an option.

It gives a holder the right to enter a swap with another party at a given time in the future. Parties usually agree on a swaption when there are uncertainties about the price movements in the future. Just like with options, the swaption will only be executed if the price is more favorable then the spot price. If the sport price upon the maturity date is more favorable, the swaption will expire.

In this situation a company will agree on a new swap, based on the current market prices. Options are a form of derivatives, which gives holders the right, but not the obligation to buy or sell an underlying asset at a pre-determined price, somewhere in the future. To determine whether it is profitable to exercise an option, the current market price spot price and the price in the option strike price need to be compared. By comparing both prices, a choice can be made to either exercise the option or let it expire.

When exercising an option there are three positions on which the holder can find themselves. The first is in the money ITM , where the strike price is more favorable than the spot price and thus it will be advantageous to exercise the option. The second is at the money ATM in which the strike and spot price are equal and so no advantage can be gained.

The third is out the money OTM , where the strike price is higher than the spot price. In this case it is better to let the option expire and buy the commodity at the current market price. There are two ways of settling an option between two parties. The first way is to physically deliver the underlying commodity.

The other way is to cash settle the option. In this way the difference between the spot and strike price is paid to the holder of the option upon exercising of the option.

An option has a few advantages over other derivatives. The most important advantage is that an option is not binding, in the way is does not obligate one to buy a commodity. Similarly, if the market price e. The seller of an option, by contrast, can lose a large sum if an option goes a long way into the money. Such large movements are rare, of course, but it would only take one instance to ruin most individual option issuers. All else equal, what should cost more to purchase, an American or a European option?

Swaps are very different from options though they can be combined to form a derivative called a swaption, or an option to enter into a swap.

As the name implies, swaps are exchanges of one asset for another on a predetermined, typically repeated basis. Such an agreement, called an interest rate swap, would buffer the bank against rising interest rates while protecting the finance company from lower ones, as in the following table:.