Exchange traded or Over The Counter (OTC) options

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An insight into OTC Derivatives

January 3 2020 Written By: EduPristine

What is Derivatives?

Derivatives are defined as the type of security in which the price of the security depends/is derived from the price of the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. The common types of derivatives include Options, Futures, Forwards, Warrants and Swaps.

Derivatives allow users to meet the demand for cost-effective protection against risks associated with movement in the prices of the underlying. In other words, users of derivatives can hedge against fluctuations in exchange and interest rates, equity and commodity prices, as well as creditworthiness.

Participants in derivatives markets are often classified as either “hedgers” or “speculators”. However, hedging and speculating are not the only motivations for trading derivatives. Some firms use derivatives to obtain better financing terms. Fund managers sometimes use derivatives to achieve specific asset allocation of their portfolios.

The two major types of markets in which derivatives are traded are namely:

Exchange Traded Derivatives

Over the Counter (OTC) derivatives

Exchange traded derivatives (ETD) are traded through central exchange with publicly visible prices.

Over the Counter (OTC) derivatives are traded between two parties (bilateral negotiation) without going through an exchange or any other intermediaries. OTC is the term used to refer stocks that trade via dealer network and not any centralized exchange. These are also known as unlisted stocks where the securities are traded by broker-dealers through direct negotiations.

With different characteristics, the two types of markets complement each other in providing a trading platform to suit different business needs. On one hand, exchange-traded derivative markets have better price transparency as compared to OTC markets. Also, the counterparty risks are smaller in exchange-traded markets with all trades on exchanges being settled daily with the clearinghouse. On the other hand, the flexibility of OTC market means that they suit better for trades that do not have high order flow or special requirements. In this context, OTC market performs the role of an incubator for new financial products.

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Why OTC?

1) The Company may be small and hence not qualifying the exchange listing requirements

2) It is an instrument that is used for hedging, risk transfer, speculation and leverage

3) OTC gives exposure to different markets as an investment avenue

4) In many cases it implies less financial burden and administrative cost for the end users (e.g. corporate)

Swaps are widely regarded as the first modern example of OTC financial derivatives. All OTC derivatives are negotiated between a dealer and the end user or between two dealers. Inter-dealer brokers (IDBs) also play an important role in OTC derivatives by helping dealers (and sometimes end users) identify willing counterparties and compare different bids and offers.

Types of OTC Derivatives

OTC Contracts can be broadly classified on the basis of the underlying asset through which the value is derived:

Interest rate derivatives: The underlying asset is a standard interest rate. Examples of interest rate OTC derivatives include LIBOR, Swaps, US Treasury bills, Swaptions and FRAs.

Commodity derivatives: The underlying are physical commodities like wheat or gold. E.g. forwards.

Forex derivatives: The underlying is foreign exchange fluctuations.

Equity derivatives: The underlying are equity securities. E.g. Options and Futures

Fixed Income: The underlying are fixed income securities.

Credit derivatives: It transfers the credit risk from one party to another without transferring the underlying. These can be funded or unfunded credit derivatives. e.g: Credit default swap (CDS), Credit linked notes (CLN).

OTC markets have two dimensions to it, namely customer market and interdealer market. In customer market, bilateral trading happens between the dealers and customers. This is done through electronic messages which are called dealer-runs providing the prices for buying and selling the derivatives. On the other hand, in the interdealer market, dealers quote prices to one other to offset some of the risk in the trade. This is passed on to other dealers within fractions. This clearly provides a view point on the customer market.

Advantages of OTC

  • These derivatives offer companies more flexibility because, unlike the “standardised” exchange-traded products, they can be tailored to fit specific needs, such as the effects of a particular exchange rate or commodity price over a given period.
  • Companies say such derivatives play a big part in helping them to provide consumers with stable prices.

RISKS managed using OTC Derivatives

Interest rate risk: Companies prefer to take loans from banks at a fixed rate of interest in order to avoid the exposure to rising rates. This can be achieved through interest rate swap which locks the fixed rate for a term of loan.

Currency Risk: Currency derivatives allow companies to manage risk by locking the exchange rate, beneficial for importer or exporter companies that face the risk of currency fluctuations.

Commodity Price Risk: Financing in terms of expansion can only be available if the future selling price is locked. This price risk protection is provided through customized OTC derivative. e.g. Crude Oil producer would like to increase production in tandem to increase in the demand. The financing will be done only if the future selling price of the crude is locked.

Disadvantages of OTC

  • Lack of a clearing house or exchange, results in increased credit or default risk associated with each OTC contract.
  • Precise nature of risk and scope is unknown to regulators which leads to increased systemic risk.
  • Lack of transparency.
  • Speculative nature of the transactions causes market integrity issues.

Conclusion

Although OTC Derivatives is a good tool for corporate, it does need more education to attract investors and be used on frequent basis.

What is over-the-counter or OTC? Definition and meaning

Over-the-counter, or OTC, refers to anything that is bought and sold directly between seller and buyer, away from a formal securities exchange – the trading is carried out directly either by computer, email, or over the telephone. An over-the-counter stock is one that is not listed on an exchange, such as a stock market. OTC derivatives are traded privately and bilaterally – between two parties – and not on a formal exchange platform.

For the meaning of over-the-counter medications, see the last section of this article.

Non-prescription medicine trading has no physical location – it does not take place at the New York Stock Exchange, the London Stock Exchange, etc. OTC trading occurs through a dealer network.

Over-the-counter or OTC refers to a trade that is not carried out on a formal exchange. In the world of finance, people often say ‘off-exchange trading’. Typically, companies offering OTC trades quote the prices at which they are willing to buy-sell assets, giving a price for each trade – unlike on-exchange trades, where several buy-sell prices are observable from many different sources. Although Nasdaq is considered a stock exchange, it operates as a dealer network, i.e. like an OTC market.

Unlike financial instruments traded on stock exchanges, agreements on the features of the financial instrument in an OTC market – what, quantity, price and conditions – are based on mutual consent.

Over-the-counter may also refer to debt securities and a wide range of financial instruments that are not traded on a formal exchange but are usually sold by investment banks that seek to raise funds for particular purposes.

In most cases, non-prescription medicine financial instruments and products are traded for smaller commercial entities that fail to meet the criteria for listing on the LSE (London Stock Exchange), NYSE (New York Stock Exchange) and other formal platforms. Sometimes they are traded as unlisted stock.

Over-the-counter markets – transparency

In an OTC market, trade can be carried out between two participants without anybody else being aware of how much money was involved.

Over-the-counter markets are typically much less transparent than exchanges. Exchanges are subject to considerably more regulations and oversight compared to OTC markets.

According to the US Securities and Exchange Commission: “The OTC Bulletin Board (OTCBB) is an electronic inter-dealer quotation system that displays quotes, last-sale prices, and volume information for many OTC equity securities that are not listed on a national securities exchange. Securities quoted on the OTCBB include domestic, foreign and American depository receipts (ADRs). (Image: adapted from finra.org. FINRA stands for Financial Industry Regulatory Authority)

When the financial market is stable, OTC markets generally function well. However, during times of financial stress, as occurred during the 2007/8 global credit crisis, their lack of transparency can exacerbate problems.

During the 2007/8 crisis, mortgage-backed securities, which were traded exclusively in the Non-prescription medicine markets, could not be priced reliably due to a lack of liquidity. Consequently, a large number of dealers withdrew from the market altogether, which made the liquidity problem considerably worse – the global credit crunch was mainly caused by a severe liquidity problem.

Over-the-counter markets

Over-the-counter markets are divided into two main branches:

Customer Market: dealers trade with institutions and corporations (their clients).

Interdealer Market: dealers trade with other dealers.

Prices that dealers quote their clients are not always the same as those quoted to other dealers. The bid-ask spread between dealer and client is often wider than between dealers.

OTC markets are mainly used to trade:

  • bonds
  • derivatives
  • currencies
  • equities such as the OTC Pink marketplaces, the OTCQB, and the OTCQX (formerly the Pink Sheets and OTC Bulletin Board)

The world’s most popular over-the-counter market is FOREX, where currencies are exchanged between parties rather than on exchanges. FOREX is decentralized and takes place twenty-four hours a day, unlike exchanges which have fixed opening hours. (Image: adapted from blog.equinix.com)

Over-the-counter – drugs

In the world of healthcare, over-the-counter medications, also known as nonprescription medicines or Rx, are those that can be purchased without needing to present a doctor’s prescription. For example, aspirin, Tylenol (paracetamol), and many cough syrups can be bought directly at a pharmacy without having to first go to your doctor to get a prescription.

The US Food & Drug Administration (FDA) has the following definition on its website:

“Over-the-counter medicine is also known as OTC or nonprescription medicine. All these terms refer to medicine that you can buy without a prescription. They are safe and effective when you follow the directions on the label and as directed by your health care professional.”

Of the top ten non-prescription medicine blockbusters in the pharmaceutical sector, eight target cough and cold symptoms. If an intelligent alien studied this chart, it would probably conclude that humans are riddled with pain and upper-respiratory tract problems. (Data source: visiongain.com/Report)

According to Mordor Intelligence, the worldwide OTC drugs market was estimated to be worth $133.25 billion annually at the end of 2020. This figure is expected to reach $220 billion in 2021. During the 2020-to-2021 forecast period, the market is expected have a compound annual growth rate (CAGR) of 10.6%.

In an article published in August 2020, Mordor Intelligence wrote:

“A switch by major pharmaceutical companies from Rx to OTC with the objective of investing less and earning more has been instrumental in the growth of the market in past 10-15 years.”

“Companies such as Pfizer, Johnson and Johnson, Sanofi, GSK etc. have increased their focus on OTC drugs development to fetch benefits from this promising market.”

The global OTC market is segmented into Latin America, North America, the Middle East, Asia-Pacific, and Europe. Western Europe and North America make up almost 42% of the global OTC market, followed by Asia-Pacific with 32%.

The top over-the-counter markets for OTC drugs in 2020 were the United States, France, Germany, China and Japan – which together accounted for almost 56% of global sales.

However, in the near future these figures are expected to change. Latin America and Asia-Pacific will grow it a significantly faster rate than the advanced economies of North America and Western Europe.

Over the next five years, the following markets are expected to grow/contract:

– China: with the fastest growth in the world.

– Latin America: with the second-fastest growth.

– The Central European will expand more rapidly that the Western European ones.

– North America will probably post a small decline – experts predict generic medicines will dominate the market (92%).

– The Japanese market, which fell by -2% over the past five years, is expected to continue shrinking.

Video – What is over-the-counter?

In this video, Amy Anderson talks about over-the-counter or OTC in the world of business and finance. She begins by explaining that OTC securities are those that were unable to make listing requirements and are not traded on the exchange – hence, they are also called ‘unlisted’.

Introduction to Over-the-Counter Options

Stuart Westmorland/Getty Images

Normally, if an investor wants to trade or speculate in options, he or she will peruse the options tables on their broker’s website. The various puts and calls for given security will be shown for different expiration dates, going out as far as a couple of years in the case of LEAPs.

These types of options are listed on an exchange and trade through a clearinghouse. Don’t panic—it sounds more advanced than it is. Without going into the technical details, what it effectively means is that the performance of your option is guaranteed by the exchange itself.

Each participant is charged a fee to help cover potential default, with the odds considered remote. In other words, if you were to buy 10 call contracts giving you the right to buy a blue-chip company at $50 per share between now and a week from now, you would pay $3 per share, or $3,000 total (each call option contract represents 100 shares, so 10 contracts x 100 shares x $3 per share = $3,000).

If that company were to go to $60 per share, you could exercise the call options and pocket the profit—in this case, $60 sale price – $53 cost (consisting of $50 for the stock and $3 for the option) or $7 per share. Thus, a 20% rise in the company’s stock resulted in a 133% gain on your options. The option you bought had to be sold by someone, perhaps a conservative investor who was selling covered calls as part of a buy-write transaction. They have to deliver the stock.

What happens if the other person, known as the counterparty, can’t? What if they died? Went bankrupt? That’s where the clearinghouse steps in and fulfills the contract. In essence, each of you was making a deal with the exchange/clearinghouse itself. Thus, there is virtually no counterparty risk.

How Over-the-Counter Options Differ from Regular Stock Options

In essence, over-the-counter options are private party contracts written to the specifications of each side of the deal. There are no disclosure requirements and you are limited only in your imagination as to what the terms of the options are. In an extreme example, you could structure an over-the-counter option with another party that required that person to deliver a set number of troy ounces of pure 24-karat gold based upon the number of whales spotted off the coast of Japan over the next 36 months. While that might be a very stupid transaction, you get the idea that you can write essentially any terms for these options.

The appeal of over-the-counter options is that you can transact in private and negotiate the terms. If you can find someone who doesn’t think your over-the-counter option proposal presents many risks to their side, you can get an absolute steal.

Counterparty Risk in Over-the-Counter Options

A major concern with over-the-counter options is that they lack the protection of an exchange or clearinghouse. You are effectively relying on the promise of the counterparty to live up to their end of the deal. If they can’t perform, you are left with a worthless promise.

Using the over-the-counter options is especially dangerous when used to hedge your exposure to some risky asset or security. When this happens, it is known as “basis risk”—your hedges fall apart, and you’re left exposed. That is why the world financial institutions panicked when Lehman Brothers failed in 2008—as a huge investment bank, they were party to countless over-the-counter options that would have entered a black hole of the bankruptcy court.

This is referred to in financial regulatory circles as a “daisy-chain” risk. It only takes a few over-the-counter derivative transactions before it becomes virtually impossible to determine the total exposure an institution would have to a given event or asset. The problem becomes even more complex when you realize that you may be in a position where your firm could be wiped out because one of your counterparties had their counterparty default on them, making them insolvent. It is why famed investor Warren Buffett had referred to unchecked derivatives as financial weapons of mass destruction.

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