What Are Over The Counter (OTC) Derivatives?
To have an expertise in making investments, you need to be well-versed with the trading terminologies. You could have heard about Over the Counter or OTC derivatives. If you are wondering: what are OTCs? Read on to know more.
Foremost, you need to be aware of derivatives trading. Derivatives are types of securities where the prices are determined by the value of its intrinsic or underlying asset. These assets could be stocks, bonds, commodities etc. The common types of derivatives trading include derivative securities such as forwards, futures, options and swaps.
Derivatives trading can provide protection against the risks associated with the price movements of the underlying assets. So, traders dealing with derivatives securities are also called hedgers or speculators. Along with hedging against price movements, derivatives trading can also allow trading firms to negotiate better terms of trade. At times, fund managers use derivatives trading to reach the targeted asset allocation in their investment portfolios.
Now, derivatives are traded in two types of markets: in a central trading exchange such as the National Stock Exchange (NSE), Bombay Stock Exchange and Multi Commodity Exchange of India Ltd (MCX) or via over-the-counter market. The derivatives which are traded through stock exchanges are known as Exchange Traded Derivatives (ETDs), while those traded between two or more different parties - without the involvement of stock exchanges or any other formal intermediary - are known as over the counter derivatives.
Types Of OTC Derivatives Market
Over the counter trading is conducted through dealer networks, and these derivatives are frequently referred to as unlisted stocks. The broker/dealer network conducts the trade in OTC derivatives through direct negotiation. There can be two types of OTC derivatives market:
Inter-dealer Markets :
Here, over the counter trading is conducted between different dealers. Dealers negotiate prices to hedge against risks.
Customer Market :
Here, over the counter trading is conducted between a dealer and a customer. Dealers provide the prices for buying and selling of derivatives to customers.
Differences Between Exchange Traded Derivatives and OTC derivatives.
||Exchange Traded Derivatives (ETDs)
||Over The Counter Derivatives (OTDs)
|Nature of transaction
||The stock exchange facilitates bilateral trading by acting as an intermediary.
||This is a private transaction between two or more parties.
|Margin in trade
||Margin is according to the stock exchange rules.
||The collateral is negotiated between the parties.
|Process of liquidation
||Simple liquidation process is followed
||Liquidation is subject to negotiation and agreement between parties
||No default risk
||This involves credit/ default risk between the involved parties.
||No price transparency
||Listed on stock exchanges with standardised terms and conditions
||Minimal regulation without the involvement of stock exchanges or any formal intermediary.
Types Of OTC Derivatives
Over the counter trading can be of the following types on the basis of the following underlying assets:
1. Interest Rate Derivatives :
Here, the underlying asset is a standard interest rate. Swaps, which involve an exchange of cash flows, over a period of time, are an example of interest rate OTC derivative trading.
2. Commodity Derivatives :
Here, the underlying assets are physical commodities such as gold, food grains etc. Forward contracts are an example of OTC trading in commodity derivatives.
3. Equity Derivatives :
Here, the underlying assets are equities. Options and Futures are an example of OTC trading in equity derivatives.
4. Forex Derivatives :
The underlying assets are changes in foreign exchange rates.
5. Fixed Income Derivatives :
Here, the underlying assets are fixed income securities.
6. Credit Derivatives :
Here, one party transfers the credit risk to another without any exchange of the underlying asset. Credit derivatives can either be funded or unfunded. Credit Default Swap (CDS) and Credit Linked Notes (CLNs) are examples of OTC trading in credit derivatives.
Types Of Risks That Can Be Managed Using OTC Derivatives:
Over the counter market trade in derivatives can allow for hedging against three types of risks:
1. Interest Rate Risk:
Here, an interest rate swap between the trading parties allows the interest rate to be fixed.
2. Currency Risk:
Here, the exchange rate is fixed or locked, thus allowing the trading parties to hedge against currency rate fluctuations. Import and export companies can benefit from using OTC currency derivatives.
3. Commodity Price Risk :
Here, the trading parties lock the future selling price of a commodity.
Advantages Of OTC Derivatives
Here’s a look at the benefits of over-the-counter trading:
- It can allow small companies to engage in trade without the requirement of being listed on stock exchanges. These companies can also stand to benefit from lesser financial and administrative costs as compared to companies which are listed on stock exchanges.
- It can be used for hedging, transferring of trading risks, and as a leverage for business operations.
- It can allow for increased flexibility as the companies don’t have to abide by the standardised norms vis-a-vis exchange traded derivatives. The products can be customised to suit the specific requirements of the company.
- It can allow companies to provide stable prices to its customers.
Disadvantages Of OTC Derivatives
Over the counter trading has some disadvantages as well. Here’s a look:
- Any OTC contract runs the associated risk of credit or default as there is no central mechanism to clear and settle the transactions.
- Any OTC contract is fraught with inherent and systemic risks, in the absence of standardised regulations and norms.
- Any OTC contract remains opaque.
- Any OTC contract is inherently speculative, thus having the possibility of creating market integrity issues.
Popularity Of Over The Counter Derivatives
OTC derivatives are popular among corporates as it hedges them against multiple risks. But it is less popular among individual investors. Dissemination of more information to individual investors about OTC derivatives can allow for a larger participation.
Thus, OTC derivatives are private contracts between counterparties, which are negotiated without the necessity of stock exchanges. It allows for increased flexibility, as the terms are negotiated and tailored to fit their requirements. Now that you know what are OTCs, begin your trading journey with confidence and poise. Do remember to choose a trusted and reliable financial partner to make prudent investment decisions. Look for features such as free Demat account and trading account, all-in-one account to invest in multiple options via a single account, cutting-edge trading platforms and the best stock and scheme recommendations.