What are the key differences between options and swaps?

Options and swaps are both types of derivative contracts used in financial markets, but they differ in several key aspects. The main differences between options and swaps are as follows:

1. Definition and Purpose:
- Options: An option is a contract that gives the holder the right, but not the obligation, to buy (call option) or sell (put option) a specific asset (such as stocks, commodities, or currencies) at a predetermined price (strike price) within a specified period (expiration date). Options are commonly used for hedging, speculation, and generating income.
- Swaps: A swap is a contract between two parties to exchange cash flows or financial instruments over a specific period. The most common types of swaps are interest rate swaps, currency swaps, and commodity swaps. Swaps are primarily used for managing risks, such as interest rate or currency fluctuations, and for altering the cash flow characteristics of assets or liabilities.

2. Obligation:
- Options: Options provide the holder with the right, but not the obligation, to exercise the contract. The holder can choose whether to exercise the option or let it expire worthless.
- Swaps: Swaps involve a contractual obligation for both parties to fulfill the terms of the agreement. Each party is obligated to make the specified payments or exchanges according to the predetermined schedule.

3. Underlying Assets:
- Options: Options can be based on a wide range of underlying assets, including stocks, bonds, commodities, currencies, and market indices.
- Swaps: Swaps are typically based on financial variables, such as interest rates, exchange rates, or commodity prices. They do not require ownership of the underlying assets.

4. Risk Exposure:
- Options: Option holders have limited risk exposure, as they can choose not to exercise the option if it is not profitable. The maximum loss for an option buyer is the premium paid for the contract.
- Swaps: Swaps expose both parties to potential risks, as they involve ongoing obligations over the contract's duration. The risk exposure depends on the underlying variables and market conditions.

5. Trading and Market:
- Options: Options are commonly traded on organized exchanges, such as the Chicago Board Options Exchange (CBOE), where standardized contracts are bought and sold. They can also be traded over-the-counter (OTC) between private parties.
- Swaps: Swaps are primarily traded over-the-counter (OTC) between private parties, such as banks, corporations, or institutional investors. They are customized contracts tailored to the specific needs of the parties involved.

6. Cost:
- Options: Options involve the payment of a premium by the option buyer to the option seller. The premium is the price of the option contract and is influenced by factors such as the underlying asset's price, volatility, time to expiration, and interest rates.
- Swaps: Swaps do not involve an upfront payment like options. Instead, they involve periodic payments or exchanges based on the agreed terms and underlying variables.

In summary, options provide the right, but not the obligation, to buy or sell an asset at a predetermined price, while swaps involve an obligation to exchange cash flows or financial instruments. Options have limited risk exposure and are commonly traded on exchanges, while swaps expose both parties to ongoing risks and are primarily traded over-the-counter.