The difference between an option and a swap. What are Derivatives in Finance?

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.

What are Swaps?

Company Y decides to exercise the option since this will be beneficial to them. There is 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.

Derivatives vs. Options: What's the Difference?

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.

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While the underlying instrument can the difference between an option and a swap 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.

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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.

Definition of Derivatives

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. Types Call option and put option are the main types of options.

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Interest rate swaps, FX swaps, and commodity swaps are commonly used swaps. 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.

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Cohan, Peter. AOL, 14 July Image Courtesy: 1.