Question

Explain Interest Rate Swaps, currency swaps, and stock options.

Answer 1

Interest Rate Swaps

A contract wherein two parties agree to exchange interest payments on a notional principal amount. The interest rates exchanged could fixed-for-floating, floating-for-fixed, or floating-for-floating. In case of floating rates, a base reference rate and a spread are agreed upon by the parties at the time of initiating the swap contract. The notional principal is usually not exchanged, but is used for calculating interest payments.

Currency swaps

A contract wherein two parties agree to exchange the principal in two different currencies at the initiation of the swap, the interest payments in different currencies during the life of the swap, and again exchange the principal in different currencies at the end of the swap.

It can be seen as an exchange of a loan in one currency for a loan in another currency.

Stock options

They are contracts which give the holder the right but not obligation to buy or sell the underlying stock at the strike price of the option. They are traded on exchanges, and are standardized in terms of expiration dates and strike prices. Call options give the right to buy the underlying stock, and put options give the right to sell the underlying stock.