Wednesday, November 9, 2011

About OTC Derivatives

What is a Derivative?
The financial instruments we've considered so far - stocks, bonds, commodities and currencies - are generally referred to as cash instruments (or sometimes, primary instruments). The value of cash instruments is determined directly by markets. By contrast, a derivative derives its value from the value of some other financial asset or variable. For example, a stock option is a derivative that derives its value from the value of a stock. An interest rate swap is a derivative because it derives its value from an interest rate index. The asset from which a derivative derives its value is referred to as the underlying asset. The price of a derivative rises and falls in accordance with the value of the underlying asset. Derivatives are designed to offer a return that mirrors the payoff offered by the instruments on which they are based. 

What Does Derivative Mean?
A security whose 
price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.

Investopedia explains Derivative
Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather 
data, such as the amount of rain or the number of sunny days in a particular region. 

Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate 
risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros.

By way of example, a few standard derivatives are listed below. The most commonly-traded derivatives - forwards, futures, options and swaps - will be described in greater detail. 

A credit derivative is an OTC derivative designed to transfer credit risk from one party to another. By synthetically creating or eliminating credit risk from one party to another. By synthetically creating or eliminating credit exposures, they allow institutions to more effectively manage credit risks. Credit derivatives take many forms. Three basic structures include: credit default, total return and credit linked swaps

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Over-The-Counter - OTC
What Does Over-The-Counter - OTC Mean?
A security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, etc. The phrase "over-the-counter" can be used to refer to stocks that trade via a dealer network as opposed to on a centralized exchange. It also refers to debt securities and other 
financial instruments such as derivatives, which are traded through a dealer network.

Investopedia explains Over-The-Counter - OTC
In general, the reason for which a stock is traded over-the-counter is usually because the company is small, making it unable to meet exchange listing requirements. Also known as "unlisted stock", these securities are traded by broker-dealers who negotiate directly with one another over 
computer networks and by phone.

Although Nasdaq operates as a dealer network, Nasdaq stocks are generally not classified as OTC because the Nasdaq is considered a stock exchange. As such, OTC stocks are generally unlisted stocks which trade on the Over the Counter Bulletin Board (OTCBB) or on the pink sheets. Be very wary of some OTC stocks, however; the OTCBB stocks are either penny stocks or are offered by companies with bad 
credit records.

Instruments such as bonds do not trade on a formal exchange and are, therefore, also considered OTC securities. Most debt instruments are traded by investment banks making markets for specific issues. If an investor wants to buy or sell a bond, he or she must call the bank that makes the market in that bond and asks for quotes.

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