What is Over the Counter (OTC) in Derivatives

What is OTC?: Meaning & Types

02 Mar 2024
By: BlinkX Research Team

In over the counter (OTC) derivatives, financial contracts are negotiated and traded between two parties without the involvement of a centralised exchange. In contrast to exchange-traded derivatives, which are standardised and regulated, OTC derivatives are more flexible and customised to meet the specific needs of the participants.

Here, we will explore the over the counter meaning in trading and discuss its importance on the financial market. We will also explore types of OTC derivatives, their underlying assets, advantages, disadvantages, and risks.

Over the Counter (OTC) Meaning

OTC meaning refers to the trading stocks of companies not listed on a stock exchange. The reason could be non-compliance with listing norms or ineligibility. Such companies might be in interesting fields, such as a popular technology or a product that has the potential for growth that investors are interested in. Over the counter derivatives markets give investors the chance to buy shares of companies that aren't listed.

Table of Content

Over the Counter (OTC) Meaning
Types of OTC Derivatives Market
Types of OTC Derivatives
Advantages of OTC Derivatives
A few risks you can manage with OTC Derivatives

Types of OTC Derivatives Market

Over the Counter derivatives are traded through dealer networks, and they're often called unlisted stocks. OTC derivatives are traded through the broker/dealer network through direct negotiation between the two parties. Moreover, knowing the OTC meaning you also must understand that the counter derivatives market can be divided into two types:

Inter-dealer Market

In this market, OTC trading is done between different dealers. To hedge against risks, they negotiate prices.
Customer Market

It's OTC trading between a dealer and a customer. A dealer provides the customer with prices for buying and selling derivatives, which they agree on.

Types of OTC Derivatives

The following kinds of OTC trading are available based on the underlying assets below:

Interest Rate Derivatives

In this case, the underlying asset is a standard interest rate. Interest rate OTC derivatives include swaps, which involve the exchange of cash flows over time.
Commodity Derivatives

The underlying assets of commodity derivatives are physical commodities, such as gold, food grains, etc. An example of OTC trading in commodity derivatives is forward contracts.
Equity Derivatives

In equity derivatives, the underlying assets are equity securities. OTC trading in equity derivatives includes options and futures.
Forex Derivatives

The underlying asset in forex derivatives is the change in the foreign exchange rate.
Fixed Income Derivatives

The underlying assets in this case are fixed income securities.
Credit Derivatives

In this situation, one party transfers the credit risk to another without exchanging any underlying assets. Moreover, there are two types of credit derivatives: funded and unfunded. OTC credit derivatives include credit default swaps (CDS) and credit-linked notes (CLNs).

Advantages of OTC Derivatives

Here are the advantages and disadvantages of OTC derivatives:

Advantages of OTC Derivatives	Disadvantages of OTC Derivatives
Allows trading for unlisted small businesses, reducing financial/administrative costs.	Lack of central clearing and settlement poses credit/default risks.
Enables hedging, risk transfer, and leveraging for businesses.	The absence of standardised regulations leads to inherent and systemic risks.
Provides flexibility by not adhering to standardised norms of exchange-traded derivatives.	OTC contracts can involve speculative trading, resulting in potential losses for traders.

A few risks you can manage with OTC Derivatives

One strategy to lower exposure to financial asset risk is to use a hedge. To hedge is to take a contrary position in a securities or investment to offset the price risk of an ongoing trade. Thus, a deal is referred to as a hedge when it is made to reduce the risk of adverse price movements in another asset. Investors can hedge against adverse fluctuations in the value of almost any type of investment, such as stocks, bonds, interest rates, currencies, commodities, and so on. There are three types of risks you can hedge against with Over the Counter derivatives:

Interest Rate Risk

Interest rate swaps provide a fixed interest rate as opposed to one that fluctuates, which helps to mitigate interest rate risk. By setting fixed interest rates, this derivative product provides stability and helps organizations better manage and plan their financial commitments. Parties can improve financial predictability and risk management techniques by entering into an interest rate swap, which allows them to stabilize cash flows and hedge against unfavourable interest rate swings.
Currency Risk

By fixing or locking in exchange rates, OTC derivatives serve a crucial role in controlling currency risk and protecting trading firms against unpredictable currency rate swings. These futures show to be quite advantageous for import and export companies, offering a way to hedge exposure to currency fluctuations in addition to risk reduction. Businesses may ensure more stable international trade operations by using OTC currency options to achieve more predictable cash flows and reduce possible losses from unfavourable currency swings.
Commodity Price Risk

Trading parties choose to use derivative contracts to set the commodity's future price when faced with price risk. Entities minimize the uncertainty and volatility associated with fluctuating commodity prices by establishing preset pricing for future transactions through the use of OTC derivatives mainly intended for commodities. By protecting supply chains, controlling manufacturing costs, and guaranteeing pricing stability, this proactive strategy helps firms reduce possible financial risks associated with erratic swings in the commodities market.

Conclusion
The OTC full form is "over the counter". The over the counter meaning in derivatives is that the contracts are traded directly between buyer and seller, without a central exchange. Furthermore, the underlying assets of OTC derivatives can include interest rates, commodities, equities, forex, fixed income securities, and credit risks.
While OTC derivatives have advantages like lower costs, risk hedging, and greater flexibility, they also have some risks. There are credit and default risks because there is no centralised clearing mechanism, and there are also speculative risks. Also, when it comes to trading stocks, the BlinkX trading app can be incredibly helpful. You can explore and capitalise on i

Frequently Asked Questions

The OTC full form is Over the Counter in the trading.

Since OTC has lenient reporting requirements and low transparency, it's generally considered risky. Often, OTC stocks have lower share prices and are highly volatile

In contrast to stock exchanges, OTC markets have never existed as “places.” They are largely informal networks of trading relationships centered around one or more dealers.

Securities that aren't listed on a national exchange are called Over the Counter (OTC) securities. The OTC market trades a lot of securities on Alternative Trading Systems (ATSs), which are quotation mediums and display broker quotes.

OTC markets are secondary markets where buyers and sellers (or their agents or brokers) trade securities.

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