Question

Discuss how value options and swaps work. Be specific in your answers.

Answer 1

Answer :-

1). Swap :- A swap is a derivative in which two counter parties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (coupon) payments associated with such bonds.

The swap agreement defines the dates when the cash flows are to be paid and the way they areaccrued and calculated. Usually at the time when the contract is initiated, at least one of these series of cash flows is determined by an uncertain variable such as a floating interest rate, foreign exchange rate, equity price, or commodity price.

The cash flows are calculated over a notional principal amount. Consequently, swaps can be in cash or collateral. They can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices. Swaps are private agreements between two parties to exchange cash flows in the future according to a pre-arranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are interest rate swaps and currency swaps.

A). Interest rate swaps: -However, this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa.

B). Currency swaps: - A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency.

2). Options :-  An option is a contract which gives the buyer (the owner or holder of the option) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specific strike price on a specified date, depending on the form of the option.The strike price may be set by reference to the spot price (market price) of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount in a premium. The seller has the corresponding obligation to fulfill the transaction—to sell or buy—if the buyer (owner) "exercises" the option.

Options are of two types – Calls and Puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

In basic terms, the value of an option is commonly decomposed into two parts :-

a). The first part is the intrinsic value, which is defined as the difference between the market value of the underlying and the strike price of the given option.

b). The second part is the time value, which depends on a set of other factors which, through a multi-variable, non-linear interrelationship, reflect the discounted expected value of that difference at expiration.

The seller may grant an option to a buyer as part of another transaction, such as a share issue or as part of an employee incentive scheme, otherwise a buyer would pay a premium to the seller for the option. A call option would normally be exercised only when the strike price is below the market value of the underlying asset, while a put option would normally be exercised only when the strike price is above the market value.

When an option is exercised, the cost to the buyer of the asset acquired is the strike price plus the premium, if any. When the option expiration date passes without the option being exercised, then the option expires and the buyer would forfeit the premium to the seller. In any case, the premium is income to the seller, and normally a capital loss to the buyer.