The expression ‘over the counter – OTC’ can be used to mean financial instruments that are traded between counterparties (dealers) either directly or through broker network. This operation is different from operations in centralized exchanges (which are otherwise classified as exchange markets)
The following table lists out the major differences between OTC and Exchange Markers
|OTC Market||Exchange Markets|
|The transactions are taken up directly by the counterparties among themselves without any intermediary||The transactions are taken up through a recognised intermediary who is otherwise named central counterparty|
|No fixed physical location||For other than electronic trading, Physical location exists|
|The rules for the transactions are mutually agreed to by the transacting counterparties||The rules for the trade transactions are prescribed by the Exchange houses|
|Transaction amount size can be customized by the counterparties||Normally Exchange houses prescribe certain standard amounts|
|Transactions can be put through for any period / duration||Exchange houses permit normal pre decided duration transactions only|
|Normally margin for such transactions are mutually agreed to upon by the counterparties in advance on a case to case basis||Exchange houses prescribe initial margin. In addition variation margin is also collected through marked to market operations|
|In addition to market risk (price risk) the counterparties will be taking up counterparty credit risk and settlement risk||Practically there will be no counterparty credit risk as the named central counterparty will settle the transaction even if one of the counterparties fail to settle. The initial margin and the variation margin collected will ensure least hitch in settlement of transaction.|
Some of the popular OTC derivative products are listed below:
Forward contracts: Forward contracts represent agreements in which the buyer agrees to purchase and the seller agrees to deliver, at a specified future date, a specified quantity of instrument or commodity at a specified price or yield. Forward contracts are generally not traded on organised exchanges and hence their contractual terms need not be standardised. At maturity agreed quantities will be exchanged as per the contract. There could be possibilities for transactions where only the difference between the contracted forward outright rate and the prevailing spot rate is settled at maturity, such as non-deliverable forwards (ie forwards which do not require physical delivery of a non-convertible currency) and other contracts for differences.
Swaps: Swaps are transactions in which two parties agree to exchange payment streams based on a specified notional amount for a specified period. Forward starting swap contracts are reported as swaps
Options: Option contracts confer either the right or the obligation, depending upon whether the reporting institution is the purchaser or the writer, respectively, to buy or sell a financial instrument or commodity at a specified price up to a specified future date.
Credit Derivatives (CDS Single / multi name): A single name CDS is credit derivative where the reference entity is a single name. A multi name CDS is a contract where the reference entity is more than one name, as in portfolio or basket CDS or CDS indices. A basket CDS is a CDS where the credit event is the default of some combination of the credits in a specified basket of credits
Index products: Multi name credit default swap contracts with constituent reference credits and a fixed coupon that are determined by an administrator such as Markit. Index products include tranches of credit default swap indices too.
FX OTC derivatives
Outright forward: Transaction involving the exchange of two currencies at a rate agreed on the date of the contract for value or delivery (cash settlement) at some time in the future (more than the spot value date or two business days later). This category also includes forward foreign exchange agreement transactions (FXA), non-deliverable forwards and other forward contracts for differences.
Foreign exchange swap: FX swap is a transaction involving the actual exchange of two currencies (principal amount only) on a specific date at a rate agreed at the time of the conclusion of the contract (the short leg), and a reverse exchange of the same two currencies at a date further in the future at a rate (generally different from the rate applied to the short leg) agreed at the time of the contract (the long leg). Both spot/forward and forward/forward swaps should be included. Short-term swaps carried out as “tomorrow/next day” transactions should also be included in this category. In Indian context such contracts are also called as ‘budlee’
Currency swap: A Contract entered into by two counterparties to exchange streams of interest payments in different currencies for an agreed period of time and to exchange principal amounts in different currencies at a pre-agreed exchange rate at maturity
Currency option: An option contract grants the right to buy or sell a currency with another currency at a specified exchange rate during a specified period. This category also includes exotic foreign exchange options such as average rate options and barrier options
OTC Interest Rate Derivatives
Forward rate agreement (FRA): Interest rate forward contract in which the rate to be paid or received on a specific obligation for a set period of time, beginning at some time in the future, is determined at contract initiation.
Interest rate swap: Agreement to exchange periodic payments related to interest rates on a single currency; can be fixed for floating, or floating for floating based on different indices. This group includes those swaps whose notional principal is amortised according to a fixed schedule independent of interest rates
Interest rate option: Option contract that gives the right to pay or receive a specific interest rate on a predetermined principal for a set period of time
Equity OTC derivatives
Equity forward: Contract to exchange an equity or equity basket at a set price at a future date
Equity swap: Contract in which one or both payments are linked to the performance of equities or an equity index It involves the exchange of one equity or equity index return for another and the exchange of an equity or equity index return for a floating or fixed interest rate
Equity option: Option contract that gives the right to deliver or receive a specific equity or equity basket at an agreed price at an agreed time in the future
Commodity OTC derivatives
Commodity forward: Forward contract to exchange a commodity or commodity index at a set price at a future date
Commodity swap: Contract with one or both payments linked to the performance of a commodity price or a commodity index. It involves the exchange of the return on one commodity or commodity index for another and the exchange of a commodity or commodity index for a floating or fixed interest rate
Commodity option: Option contract that gives the right to deliver or receive a specific commodity or commodity index at an agreed price at a set date in the future
We will discuss each of these products in greater detail one by one in due course of time