Everything You Need to Know About OTC Derivatives Market

What is Over-the-Counter?

Trading between two parties that does not take place on a regulated exchange is known as over-the-counter (OTC) trading. Over-the-counter (OTC) trading occurs through dealer networks in the decentralized, online over-the-counter markets.

In contrast to trading on regulated exchanges, over-the-counter trading does not restrict itself to the exchange of solely standardized objects (e.g., a clearly defined range of quantity and quality of products). As an additional downside, prices are only sometimes made public. Due to the bilateral nature of OTC contracts, each party may be concerned about the credit risk of its counterparty.

Over-the-counter (OTC) securities cover various currencies, commodities, and other assets. Equities, debt securities, and derivatives are examples of OTC financial instruments.

Why OTC?

1) It paves the way for private enterprises to transact business without having to become public on a stock exchange. These businesses will have lower financial and administrative costs than their publicly traded counterparts.

2) It is a hedge, risk transfer, speculation, and leverage tool.

3) Trading over-the-counter (OTC) allows investors access to many markets.

4) It often means less financial and administrative expense for the people using the service (e.g. corporate)

5) It can provide more leeway for businesses, as they need not conform to the uniform standards applicable to exchange-traded derivatives.

Types of OTC Derivatives Market

Derivatives traded OTC are often referred to as "unlisted stocks" because of how the trades are executed through dealer networks. The broker-dealer system facilitates Over-The-Counter (OTC) derivatives trade by bilateral agreement between the parties involved. There are two possible forms of the over-the-counter derivatives market:

Inter-dealer Markets:

Here, various dealers engage in OTC trading with one another. Their goal in price negotiations is to reduce exposure to potential dangers.

Customer Market:

In this setting, a dealer and a client engage in OTC trading. Customers negotiate with dealers to establish prices for purchasing and selling derivatives.

Types of OTC Derivatives

Based on the underlying assets listed below, over-the-counter trading can take the following forms:

1. Interest Rate Derivatives:

A normal interest rate is an underlying asset in this case. For instance, swaps are a type of interest rate OTC derivative trading involving the exchange of cash flows over a specific period.

2. Commodity Derivatives:

Commodity derivatives' underlying assets are commodities like gold, food grains, etc. One type of commodities derivative traded over the counter is the forward contract.

3. Equity Derivatives:

A derivative in which equities are the underlying asset is called an equity derivative. In equity derivatives, options and futures are examples of OTC trading.

4. Forex Derivatives:

FX derivatives are backed by changes in foreign exchange rates as underlying assets.

5. Fixed Income Derivatives:

Fixed-income securities are the underlying assets.

6. Credit Derivatives:

In this scenario, one party gives another their share of the credit risk without exchanging assets. Funded credit derivatives are the most common type. However, unfunded ones do exist. Over-the-counter (OTC) trading in credit derivatives includes instruments like credit default swaps (CDS) and credit-linked notes (CLN).

RISKS managed using OTC Derivatives

Interest rate risk: 

Businesses often opt for fixed-rate bank loans to protect themselves from the potential financial impact of interest rate increases. A loan's fixed interest rate can be locked in for the duration of the loan by using an interest rate swap.

Currency Risk: 

Importers and exporters dealing with currency fluctuations risk can benefit from using currency futures to lock in the exchange rate.

Commodity Price Risk: 

Expansion financing is only possible if the expected sales price is set in stone. Customized over-the-counter derivatives provide this insurance against price fluctuations. Some industries, like the oil industry, would want to see demand rise parallel to output increases. If crude prices are guaranteed to rise at a specific rate in the future, then financiers will be willing to back the project.

Conclusion

Over-the-counter derivatives are a type of contract negotiated directly between two parties outside of a centralized stock market. Because the agreement may be discussed and shaped to meet the needs of the two parties, it offers more leeway for compromise. Because of your newfound familiarity with OTCs and International Trading Group, you may confidently enter the trading world. On the other hand, selecting a trustworthy and dependable financial partner is crucial for making sound investment choices.