Mastering the Principles of OTC Derivative Trading

If you are not someone who practices in finance then it can be very difficult to understand the various ongoings and procedures. Half of the reason why this is the case is because of the different terminology used. This is confusing to most. This article deals with OTC derivatives in particular. By the time you have finished reading this post, you should know everything you need to know about this topic.

Derivative Trading
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So, let’s dive right in… what are OTC derivatives? The best way to begin explaining this is to split up the two words. Let’s deal with ‘derivatives’ first. A derivative is essentially a financial product. The value of this product has been derived from an underlying asset – now you can see why the name ‘derivative’ has been given. The underlying asset can be a whole host of things, such as oil or gold (commodities), or S&P (an index) or the stock of a company. You can read about asx block chain companies online, as this is one of the more recent progressions in stock businesses. So, that’s one part of the term dealt with.

So, what’s OTC? Well, OTC stands for over the counter. Essentially a derivative can be split into one of two categories; either OTC or listed. A listed derivative is one that is traded on exchanges. It is a lot more structured. It consists of standardized contracts. The underlying assets, the mode of settlement and the quantities are all determined by the exchange. However, an OTC derivative is completely different. It is a private exchange whereby the contracts are tailor-made by the counterparties that are involved.

OTC derivatives are definitely growing in popularity at the moment. One of the main reasons why this is the case is because they can be altered in order to suit the exact needs in relation to risk and returns. This extra control is something that most people like.

There are various different types of OTC derivatives. These are evidently classified based on the underlying asset or the commodity that derives the value. Let’s have a look at some examples in further detail in order to give you a better picture…

  • Commodity Derivatives – These were mentioned a little bit earlier in the article when the examples of gold and oil were given. Another good example is wheat. OTC commodity derivatives are typically forwards.
  • Interest Rate Derivatives – There are various different types of interest rate OTC derivatives used nowadays. These include FRAs, Swaptions and Swaps.
  • Fixed Income – In these instances, the underlying asset is those that are fixed income products. An obvious example would, of course, be a mortgage.
  • Credit Derivatives – A great example of a credit derivative would be a CDS on fixed-income securities. This stands for Credit Default Swaps. In this instance, the underlying asset is the credit event, quality or risk of a particular counterparty or asset.
  • Equity Derivatives – The final example is equity derivatives i.e. an equity index or equities would be the underlying asset. Thus, an example of OTC derivatives in this instance would be forwards or equity swaps.

Hopefully, you now know the answer to the all-important question; what are OTC derivatives? In a nutshell it is the private exchange of a financial product, which could be anything from a commodity to an index.