Otc Derivatives Overview

What are OTC derivatives? Derivative is a financial product whose value is derived from an underlying which can be equity of any company, index like S&P, or commodity like gold, wheat, oil etc. Based on where you are trading, derivatives can be classified as OTC (over the counter) derivatives or Listed Derivatives (which trade on exchanges). Overthe-counter or OTC derivatives are private, tailor made contracts between two counterparties. In contrast Listed Derivatives are standardized contracts i.e. the underlying and the quantity is defined by the exchange. These instruments are backed by the full faith of the clearing house. OTC derivatives provide high degree of flexibility and customization as these are private contracts between two counterparties tailored to suit their specific needs. Since there is no exchange/clearing house in the middle there is considerable amount of credit or default risk with each contract. Following are the different types of OTC derivatives; note that this classification is based on the underlying asset or commodity from which the value of derivative is established. 1. Interest rate: Underlying is standard interest rate i.e. London Interbank offer rate, rate on US treasury bills etc. Examples of interest rate OTC derivatives include Swaps, Swaptions, and FRA etc. 2. Credit derivatives: Underlying is the credit quality, risk or credit event of a particular asset/counterparty etc. One example is Credit Default Swaps on fixedincome securities which make payments if the underlying bonds are downgraded by credit rating agencies or the company which issued the bond defaults. 3. Commodities: Underlying are physical commodities like wheat, gold etc. Examples are forwards. 4. Equities: Underlying are equities or index. Example Equity Swap or forwards. 5. FX: As the name suggests underlying is Foreign exchange. 6. Fixed Income: Underlying are FI products. These also can be mortgages.