Deriving their value from an underlying asset or a cluster of assets, derivatives are considered one of the most popular financial instruments in Indian equity markets. Among the variety of derivative contracts offered, swaps and options are often used for speculation and hedging. In this article, we will take a closer look at some key differences between swaps and options and also explore their respective characteristics.
What is an option?
Options grant you the right to buy or sell an asset without obliging you to do so at a predetermined price (known as a strike price) and within a stipulated time period (known as an expiration date).
Two types of options contracts are commonly exercised—call options and put options. The right to buy is known as a call option, whereas the right to sell is known as a put option. In an options contract, the buyer has to pay a premium to the seller.
What is a swap?
Swap derivatives, on the other hand, are financial contracts between two parties who have agreed to exchange cash flows or liabilities in accordance with certain terms and conditions. Usually, these cash flows consist of bonds and loans.
The standout feature of this derivative contract is its notional amount, which forms the basis of the cash flows being traded instead of the actual principal amount. Fixed and variable cash flows are swapped by the parties depending on aspects such as currency rates, interest rates, or index rates.
Let us take a look at different types of swap derivatives.
- Interest rate swaps: Such derivatives enable the hedging of interest rate risks. The two involved parties exchange fixed-rate debt and variable-rate debt instruments based on a notional sum.
- Currency swaps: Protecting investors against movements in exchange rates, currency swaps allow the transfer of interest rates and principal amounts in different currencies. Such swap contracts are different from interest rate swaps, as currency swaps have specific interest obligations to be met and are not offset by notional principal sums.
- Commodity swaps: These swap contracts facilitate the exchange of cash flows, which are based on the prices of commodities.
- Debt equity swaps: With this transaction, the parties interchange debt and equity. These swaps are used as a means to readjust financial obligations, enabling the exchangers to turn debt into equity or do the opposite.
- Total return swaps: In such contracts, parties barter the entire return of an underlying asset for a predetermined interest rate. Thus, one participant enjoys yields from an asset without ownership while the other remains the total return receiver.
Outlining the main differences between swaps and options
| Options | Swaps | |
| Trading platform | These are traded in a standardised fashion on public exchanges or over-the-counter (OTC). | Typically traded over-the-counter (OTC). |
| Obligations | The buyer has the right but is not obliged to exercise the contract. In case the buyer exercises the right to buy, the seller will be obligated to fulfil the contract. | Both parties have to honour the cash flow obligations with the stipulated terms and conditions. |
| Premium | The purchase of an option contract comes with the cost of a premium. | Swap contracts don’t require any upfront premium. |
| Trade type | Options trade the actual value of an underlying asset. | Swaps involve the exchange of cash flows and not only the underlying value of an asset. |
| Nature of the process | Options are easier to manage as they are traded on public exchanges with standardised terms. | Swaps are relatively more complex as they are privately handled and necessitate drawing legal paperwork. |
| Types | Call and put are two main types of options contracts. | Interest, currency, and commodity are popular forms of swap contracts. |
What is a swaption?
Also referred to as a swap option, swaptions are a fiscal instrument that give the buyer the right to exercise a contract without obligations, enabling them to participate in a predetermined swap agreement. In exchange for the privilege of right, the buyer is required to pay an upfront premium to the issuer of the contract. Often, swaptions are used as opportunities to hedge against any fluctuations in interest rates or secure advantageous interest rates.
Here are three popular types of swaption contracts.
- Payer swaptions: In this contract, the buyer wins the right to enter the swap arrangement without any obligation where they become a fixed-rate payer and variable-rate receiver.
- Receiver swaption: Such deals are the exact opposite of a payer swaption. Here, the buyer enters the swap agreement without obligations, where they receive a fixed rate and pay the floating rate.
- Straddle swaptions: Using these contracts, the buyer purchases both fixed and floating rates of a swap contract.
Also Read: How to do Bank Nifty Intraday Options Trading
Conclusion
Utilising derivative contracts like swaps and options can be a smart solution to evade volatile stock fluctuations. Options offer some level of security by giving you the freedom to buy without obligation, along with the standardised practices of the public exchanges. Alternatively, swaps allow you to neutralise possible risks of unstable interest or currency rates. Even so, swaps and options come with their own set of inherent risks, which need to be astutely scrutinised so that you can arrive at the most viable investment decision.
