Derivatives are a kind of security, the price of which depends on the price of the primary asset like bonds, stocks, currencies, market indices, etc. Future, Options, Forwards, Swap, LEAPS, Baskets, Swaptions and Warrants are the most common derivatives available in the market. Derivatives provide a cost effective protection against the uncertain risks linked to the fluctuation of prices. Derivatives are not only used for the purpose of speculation or hedging, but are also used to get better financing terms or to reach a certain asset allocation of their portfolio.
Over The Counter Derivatives are exchanged between 2 parties without involving any intermediaries. There are no centralized exchanges and are also known as unlisted stocks. The 2 parties involved can either be an end user and a dealer or they can be 2 dealers. The OTC market has 2 counterparts, the customer market and the interdealer market.
Types of OTC Derivatives
- Interest Rate Derivatives: The standard interest rate is the primary asset. For example, USTBB, FRAs, LIBOR, Swaps etc.
- Commodity Derivatives: A particular physical commodity is the primary asset. For example, Forwards.
- Forex Derivatives: Foreign Exchange is the primary asset.
- Equity Derivatives: Equity Securities like F&O are the primary asset.
- Fixed Income Derivatives: Fixed Income Securities are the primary asset.
- Credit Derivatives: These can be either funded or unfunded. It transfers the risk from one party to another without any transfer of the primary asset.
Pros of Derivatives
- The OTC market is flexible and is suited for transactions that do not have any special requirements. They are thus, like an incubator for new products in the financial market, as the new company might not qualify due to the lack of exchange listing requirements.
- Derivatives allow companies to get new capital sources at reasonable prices.
- It is used as a tool for risk transfer and leverage. Not only that, it is commonly known as the instrument that enables speculation and hedging.
- Derivatives can allow purchase expense stabilization, hedge currency rate stabilization and enable future price forecasts.
- The cost associated with the administration of derivatives is low and hence puts less financial pressure.
- Derivatives provide customers with stable prices and can be tailored to meet the needs of the customer.
- OTC Derivatives help manage risks associated with interest rate, currency and commodity price.
Cons of Derivatives
- People usually say that OTC market is not transparent enough and leads to integrity issues as it is based on speculation and hedging.
- One must be sure of the degree of accuracy of the derivatives. Proper research must be done as, if they are not used accurately, it can result in severe losses.
- There is systematic risk involved.
- The OTC Market has risks associated with credit and default due to the absence of clearing houses.
- The risk associated with a particular derivative is similar to the risk associated with the primary asset.
Therefore, Derivatives can be seen as an extremely versatile tool that can be used for speculation, hedging and risk management. Because they are flexible and versatile, institutions must formulate regulations to manage the exchange of Derivatives.