CFM13080 - Understanding corporate finance: derivative: ‘over-the-counter’ contracts

Over-the-counter contracts

Exchanges trade in a limited number of standard contract types. Exchange-traded products are therefore relatively inflexible. A company with a particular risk exposure may find it difficult to hedge it precisely using exchange-traded contracts, and may therefore enter into an over-the-counter (OTC) contract, normally with a bank or similar financial institution.

The advantage of OTC contracts is that they are available on a wide range of underlying assets, and the terms of the contract can be tailored to fit the company’s particular requirements. For example, a company exposed to movements of the US dollar against sterling might hedge its exchange risk by using traded currency futures or options. A company whose exposure is some less usual currency, like the Polish zloty or the Thai baht, would probably use an OTC contract to hedge.

There are three main disadvantages to OTC contracts.

• They are generally more expensive than exchange-traded products.
• Someone who holds an exchange-traded contract can close out the position at any time by entering into an equal and opposite transaction. For example, a company which has sold interest rate futures (CFM13290) can close out the position by buying back the same contracts at the prevailing market rate. In contrast, someone who is a party to an OTC contract may not be able to sell the contract to a third party, although a relatively liquid market has now developed in some types of OTC contract.
• Unlike exchange-traded contracts, where a clearing house is interposed between buyer and seller, someone who holds an OTC contract will lose money if the counterparty defaults on his obligations. The risk of this happening is in practice relatively small because most OTC contracts are made with major banks and financial institutions.

Given the risks, the documentation of such contracts is critical, see CFM13090.