What Are Over The Counter (OTC) Derivatives?

To have expertise in investing and making profits, you need to be well-versed with all trading terminologies. Among various investment instruments that can allow you to earn hefty returns, Over-the-Counter or OTC derivatives are one of them. If you are unaware of such an investment, this blog will shed light on What are OTC Derivatives. However, before you move on to learn about OTC derivatives, you need to learn about derivatives trading.

What are Derivatives and 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. Some common types of derivatives trading include derivative securities such as forwards, futures, options and swaps.
Derivatives trading can protect against the risks associated with the price movements of the underlying assets. The traders dealing with derivatives securities are 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 manage their investment portfolios’ targeted asset allocation.
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 an over-the-counter market. The derivatives traded through centralised stock exchanges are known as Exchange Traded Derivatives (ETDs). In contrast, 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 derivatives trading is conducted through dealer networks, and these derivatives are frequently referred to as unlisted stocks. The broker/dealer network conducts OTC derivatives trade through direct negotiation in which the two parties agree upon the terms. There can be two types of OTC derivatives market:

Inter-dealer Markets::

Here, over-the-counter trading is conducted between different dealers. They 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 the customers, which are agreed upon by the 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 set according to the stock exchange rules. The collateral is negotiated between the parties that can be any amount or asset.
Process of liquidation A simple liquidation process is followed. Liquidation is subject to negotiation and agreement between the two parties.
Risk exposure No default risk. This involves credit/ default risk between the involved parties.
Price transparency Price transparency. No price transparency.
Regulation Listed on stock exchanges with standardised terms and conditions. Minimal regulation owing to no involvement of stock exchanges or any formal intermediary.

Types of OTC Derivatives

Over-the-counter trading can be of the following types based on the below-listed 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:

Commodity derivatives have underlying assets that are physical commodities such as gold, food grains etc. Forward contracts are an example of OTC trading in commodity derivatives.

3. Equity Derivatives:

In equity derivatives, the underlying assets are equities. Options and Futures are an example of OTC trading in equity derivatives.

4. Forex Derivatives:

In 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 underlying asset exchange. 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, switching from a floating interest rate.

2. Currency Risk:

The exchange rate is fixed or locked using OTC derivatives, 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

The benefits of over-the-counter trading include:

  • It allows small companies to engage in trade without being listed on stock exchanges. These companies can also stand to benefit from lesser financial and administrative costs compared to companies listed on stock exchanges.
  • It can be used for hedging, transferring trading risks, and as 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.
  • It can allow companies to provide stable prices to their 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.
  • OTC contracts are inherently speculative, thus having the possibility of creating market integrity issues and forcing traders to make losses.

Conclusion

OTC derivatives are private contracts between counterparties negotiated without stock exchanges. It allows for increased flexibility, as the terms are negotiated and tailored to fit the requirements of the two parties. Now that you know what are OTCs, you can effectively begin your trading journey with confidence and poise. However, choosing a trusted and reliable financial partner is wise to make prudent investment decisions. Look for features such as a free Demat account and trading account, an all-in-one account to invest in multiple options via a single account, cutting-edge trading platforms and the best stock and scheme recommendations.

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