A derivative is a security whose price is based on or generated from one or more underlying assets. The value of the underlying asset is impacted by value changes. Some of the most common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indexes.
Depending on where they are exchanged, derivatives can be classified as over the counter or exchange traded. Over-the-counter derivatives are private financial contracts between two or more counterparties. The underlying assets, the quantity of the underlying assets, and the settlement are all established by the exchange, whereas listed derivatives are more structured and standardized contracts that trade on exchanges and are subject to further regulation.
Over-the-counter derivatives are private contracts that are negotiated directly between participants as opposed to going through an exchange or other formal middlemen, albeit a broker may help with the transaction arrangement. As a result, over-the-counter derivatives may be modified to precisely meet each participant’s risk and return criteria. Because there is no clearing corporation, this type of derivative offers freedom but also poses a credit risk.
Through dealer networks, over-the-counter derivatives trading is carried out. These derivatives are frequently referred to as unlisted stocks. OTC derivatives trades are carried out by the broker/dealer network through direct negotiations in which the terms are agreed upon by both parties. OTC derivatives markets may be of two different types:
Markets between Dealers:
Over-the-counter trading takes place here between many dealers. To protect themselves from risks, they bargain prices.
Here, a dealer and a consumer engage in over-the-counter trading. Customers and dealers agree on pricing for purchasing and selling derivatives. These prices are provided by dealers to customers.
OTC derivatives include things like forwards, swaps, and exotic options, among others.