Question

Explain Interest Rate Swaps, currency swaps, and stock options

Answer 1

interest rate swaps are derivative contracts which involves exchange of rates between two parties on underlying debt, based on a specified principal amount. IRD are forward contracts which hedges the risk of change in interest rate over the time period. IRD allows investors to offset the risk of this fluctuating interest rates. IRD are generally based on bonds which have adjustable rate interest payment that change over time. the interest rate could be however fixed or floating to reduce the risk or increase the exposure to interest fluctuations. example: one company may have a bond that pays LIBOR a rate of 4.8%, while the other party, party with interest rate swap shall provide a fixed interest payment of 5%. this way IRD can hedge over the interest rate fluctuation.

currency swaps is one of the interest rate derivative which is also known as cross currency swap which involves exchange of interest and sometimes principal of one currency swap for another currency's interest and principal. this contract is made between two foreign parties. it works like making a loan in one currency say, dollar for principal amount and interest amount to a equal value in another currency say, yen. the amounts are exchanged at spot rate. example: party A from U.S. makes a payment to party B for 10 million dollars however party B on maturity makes the payment of 10.7 million yen. another purpose of currency swap is to keep the value of foreign exchange reserves with central banks.

stock options: it is a right but not obligation of the investor to buy or sell a stock at any time until maturity for a price given in the option. stock options are used to hedge the risk against uncertainity of the performance of its underlying assets.

they are of primarily 2 types put option and call option

call option are made to purchase the asset at an agreed price irrespective of the current market prices. if the put option price is lower than the market price then the put option is exercised however if market prices are favorable then there is no obligation to exercise the put option.

put options are made to sell the underlying assets of put option. if market prices are higher you would not exercise the put option as market is giving better price over the strike price but in contrast if market prices fall you can hedge the risk of falling prices and exercise put option to sell the asset at strike price which is higher than market price and earn profits.