An over-the-counter derivative is a financial contract with terms privately negotiated between two parties, unlike a derivative with standardized terms that is traded on an exchange. Derivatives reduce one party's risk to exposure by transferring the risk to another party seeking to take on that exposure.
Companies use over-the-counter derivatives because they are a flexible method of managing the risks associated with their business. Terms such as maturity date and collateral are customized according to each party's needs. The parties then trade the derivatives directly with each other. The value of a derivative is derived from the value of an underlying asset or value, such as credit risk or currency.
A swap is an OTC derivative where cash flows are exchanged on an agreed upon schedule. For example, if the underlying asset is currency, a cross-currency swap is an interest rate swap where the cash flows are in two different currencies. Credit default swaps are used by financial institutions like banks to manage credit risk. They can buy credit default swaps to reduce exposure to credit risk, allowing them to increase their capability to make loans. In a credit default swap, the buyer makes payments to another entity -- often an insurance company or another bank -- for a specified period, during which the entity agrees to compensate the buyer if there is nonpayment of a third party loan. In effect, the lending bank is buying insurance against the possibility that its borrowers might default or suffer from a significantly reduced ability to repay their loans.
Forwards and Options
A forward, another example of an OTC derivative, is an agreement to buy or sell an asset at a future date at a forward price, or a price specified and locked in today. For example, a currency forward is a contract to exchange cash flows in two different currencies at a specified future date. An option, also a type of OTC derivative, gives the buyer the right to buy or sell an asset at a given price within a specified period. A currency option gives the buyer the right, without obligation, to exchange one currency for another at a predetermined exchange rate until the expiry date.
Other Underlying Assets
In addition to credit risk and currency, the value of OTC derivatives can be based on assets like commodities, bonds and shares of stocks. Reference values, such as an equity index, can also be used to determine the value of these derivatives. Such derivatives are used for a variety of purposes, from hedging against movements in currency values or the price of commodities, to pure speculation. The risk associated with them depends on many factors, but their widespread use by institutions and companies mean they can have a significant influence on markets and the economy at large.