Options and Swaps Explained Simply with Examples

Options

What They Are: Options are financial contracts that give the buyer the right, but not the obligation, to buy or sell an asset at a predetermined price (strike price) before or on a specific date (expiration date).

Types of Options:

• Call Option: Gives the right to buy an asset.
• Put Option: Gives the right to sell an asset.

Examples:

• Call Option: Suppose you buy a call option for a stock with a strike price of £50, and you pay a premium of £5. If the stock price rises to £60, you can buy it at £50 and sell it at £60, making a profit of £5 (£60 - £50 - £5 premium).
• Put Option: Suppose you buy a put option for a stock with a strike price of £50, and you pay a premium of £5. If the stock price falls to £40, you can sell it at £50, making a profit of £5 (£50 - £40 - £5 premium).

Swaps

What They Are: Swaps are financial agreements where two parties exchange cash flows or other financial instruments. The most common types are interest rate swaps and currency swaps.

Types of Swaps:

• Interest Rate Swap: Exchange of fixed interest rate payments for floating interest rate payments.
• Currency Swap: Exchange of principal and interest payments in one currency for principal and interest payments in another currency.

Examples:

• Interest Rate Swap: Company A has a loan with a fixed interest rate but prefers a floating rate. Company B has a loan with a floating rate but prefers a fixed rate. They agree to swap their interest payments. Company A pays Company B's floating rate, and Company B pays Company A's fixed rate.
• Currency Swap: Company C (US) and Company D (Europe) agree to swap $50 million for €40 million. Company C pays interest in euros, and Company D pays interest in dollars. At the end of the swap, they re-exchange the principal amounts.