Difference Between Options and Swaps

Both options and swaps are derivatives; i.e. financial instruments whose value depends on the value of an underlying asset. Derivatives are used to hedge financial risks. The key difference between option and swap is that an option is a right, but not an obligation to buy or sell a financial asset on a specific date at a pre-agreed price whereas a swap is an agreement between two parties to exchange financial instruments.

CONTENTS
1. Overview and Key Difference
2. What are Options
3. What are Swaps
4. Side by Side Comparison – Options vs Swaps
5. 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. But this is not an obligation. The date at which the option should be exercised is referred to as the ‘exercise date’ and the price at which the option should be exercised is referred to as the ‘strike price’. The price that should be paid to acquire the option is called the ‘option premium’. This amount is not recoverable irrespective of whether the option is exercised or not. 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.

E.g. PQR is an oil producer who is approached by Company Y who states that it wishes to buy 1,000 barrels at $ 850 per barrel of oil at the end of 6 months (as of 31^st July 2017). PQR agrees to sell an option of $3,000 for this deal. During the 6 month period, Company Y prefers to see the price of an oil barrel exceeds $850, since then it will be able to profit from the deal. At the end of 6 months, the price of an oil barrel has increased to $ 1,200. Company Y decides to exercise the option since this will be beneficial to them. However, since the option writer (PQR) agreed to sell a barrel at $850, this will be the price applicable for the 1,000 barrels at the time of exercising the option. Thus the total income for Company Y is,

Price paid for the oil (1,000* 850)                = $ 850,000

Option premium                                           = ($   3,000)

                                                                            = $ 847,000

Put Option

A put option is a right to sell a financial asset on a pre-agreed date at a pre-agreed price. There is no obligation to sell the asset on the specific date; thus, the option will be exercised at the discretion of the seller. The exercising of a put option is similar to the call option; the difference is that the seller will want the price of the asset to decrease below the option price for he\\she to make a profit.

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. 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. 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.

Interest Rate Swaps

This is a very popular type of swap where the parties exchange cash flows based on a notional principal amount (this amount is not actually exchanged) in order to hedge against interest rate risk or to speculate.

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. 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).

What is the difference between Options and Swaps?

Summary – Options vs Swaps

Options and swaps are very popular hedging techniques used in today’s commercial world. In fact, by 2010 world derivate market was estimated to have exceeded $1.2 quadrillion and options and swaps accounted for a major portion of it. 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.”Swap.” Investopedia. N.p., 30 Dec. 2015. Web. 20 Mar. 2017.
2.”Option.” Investopedia. N.p., 25 Mar. 2016. Web. 20 Mar. 2017.
3.”Types of Swaps | Derivatives Risk Management Software & Pricing Analytics | FINCAD.” Types of Swaps | Derivatives Risk Management Software & Pricing Analytics | FINCAD. N.p., n.d. Web. 20 Mar. 2017.
4. “Exchange-traded versus Over-the-counter (OTC) Derivatives.” Finance Train. N.p., 17 July 2016. Web. 20 Mar. 2017.
5.Cohan, Peter. “Big Risk: $1.2 Quadrillion Derivatives Market Dwarfs World GDP.” AOL.com. AOL, 14 July 2016. Web. 20 Mar. 2017.

Image Courtesy:
1. “Vanilla interest rate swap with bank” By Suicup – Own work (CC BY-SA 3.0) via Commons Wikimedia