What is OTC Derivatives?

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I am very new to this concept of OTC derivatives. However, I was always very inquisitive about learning what is OTC derivatives meaning. For me, it was difficult to understand as I am still struggling to understand the stock market. Nonetheless, one fine day my father who is an expert in stock market dealings highlighted a few insights about the same.

I would like to share a few glimpses of what I learned from him about OTC derivatives.

An Over-the-Counter (OTC) derivative is a financial contract that is not traded on a stock market and can be customised to meet the needs of each participant.

A derivative is a financial instrument whose price is based on or generated from one or more underlying assets. The underlying asset's variations dictate its value. Stocks, bonds, commodities, currencies, interest rates, and market indexes are the most frequent underlying assets. Derivatives can be categorised as over-the-counter or exchange-traded, depending on where they are traded.

A financial transaction that is created between two counterparties with minimum intermediation or regulation is known as an Over-the-Counter (OTC) derivative.

OTC derivatives have no standardised nomenclature and are not traded on a stock exchange.

A forward and a futures contract, for example, can both represent the same underlying, but the former is Over-the-Counter (OTC), while the latter is exchange-traded.

The trading of over-the-counter derivatives is done through dealer networks, and these derivatives are often referred to as unlisted stocks. The OTC derivatives trade is conducted by the broker/dealer network through direct discussion, in which the two parties agree on the conditions. OTC derivatives markets can be of two types:

• Inter-dealer markets:

Over-the-Counter trading is undertaken between different dealers in inter-dealer markets. They bargain prices to protect themselves from risk

• Consumer Market:

This is where a dealer and a customer do over-the-counter trading. Clients agree on pricing for purchasing and selling derivatives, and dealers supply those prices to customers

Based on the underlying assets indicated below, Over-the-Counter trading can be of the following types:

• Interest Rate Derivatives:

 A regular interest rate serves as the underlying asset. Swaps are an example of interest rate OTC derivative trading because they involve an exchange of cash flows over a period of time

• Commodity Derivatives: 

Commodity derivatives involve physical commodities as underlying assets, such as gold, and food grains, and so on. 

• Equity Derivatives:

The fundamental assets in equity derivatives are stocks. Options and futures are examples of OTC equity derivatives trading

• Forex Derivatives: 

The underlying assets in forex derivatives are changes in foreign exchange rates.

• Fixed Income Derivatives:

Fixed income securities serve as the underlying assets.

• Credit Derivatives: 

In credit derivatives, one party transfers credit risk to another without exchanging any underlying assets. There are two types of credit derivatives: funded and unfunded. Credit Default Swaps (CDS) and Credit Linked Notes (CLNs) are two forms of credit derivatives traded over the counter.

OTC derivatives provide more flexibility because the conditions are negotiated and suited to the needs of both parties. Now that I know what is OTC derivatives meaning, I may confidently and poisedly begin my trading experience.

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