Over-the-Counter Derivative

What Is an Over-the-Counter (OTC) Derivative?

An over-the-counter (OTC) derivative is a financial contract that does not trade on an asset exchange, and which can be tailored to each party's needs.

A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indexes. Depending on where derivatives trade, they can be classified as over-the-counter or exchange-traded (listed).

How Over-the-Counter Derivatives Work

Over-the-counter derivatives are private financial contracts established between two or more counterparties. In contrast, listed derivatives trade on exchanges and are more structured and standardized contracts in which the underlying assets, the quantity of the underlying assets and settlement are specified by the exchange and subject to greater regulation.

Over-the-counter derivatives are instead private contracts that are negotiated between counterparties without going through an exchange or other type of formal intermediaries, although a broker may help arrange the trade. Therefore, over-the-counter derivatives could be negotiated and customized to suit the exact risk and return needed by each party. Although this type of derivative offers flexibility, it poses credit risk because there is no clearing corporation.

Examples of OTC derivatives include forwards, swaps, and exotic options, among others.

Example: Forwards vs. Futures

Forward and futures contracts are similar in many ways: both involve the agreement to buy and sell assets at a future date and both have prices that are derived from some underlying asset.

A forward contract, though, is an arrangement made over the counter between two counterparties that negotiate and arrive on the exact terms of the contract—such as its expiration date, how many units of the underlying asset are represented in the contract, and what exactly the underlying asset to be delivered is, among other factors. Forwards settle just once at the end of the contract. Futures, on the other hand, are standardized contracts with fixed maturity dates and uniform underlyings. These are traded on exchanges and settled on a daily basis.

Example: Swaptions

As another example, a swaption is a type of over-the-counter derivative that is not traded through exchanges. A swaption (or swap option) grants the holder of the security the right to enter into an underlying swap. However, the holder of the swaption is not obligated to enter into the underlying swap.

There are two types of swaptions: a payer and a receiver.

• A payer swaption gives the owner the right to enter into a specified swap where the owner pays the fixed leg and receives the floating leg.
• A receiver swaption gives the owner the right to enter into a swap in which they receive the fixed leg and pays the floating leg.

The buyers and sellers of this over-the-counter derivative negotiate the price of the swaption, the length of the swaption period, the fixed interest rate, and the frequency at which the floating interest rate is observed.