Over-The-Counter Market 

Mean?
A decentralized market of securities not listed on an exchange where market participants trade over the
telephone, facsimile or electronic network instead of a physical trading floor. There is no central exchange
or meeting place for this market

Introduction to the basic concept of

derivatives
Derivatives in general refer to contracts that derive from another - whose value
depends on another contract or asset. Derivatives are essentially devised as a hedging
device to insulate a business from risks over which a business has no or little control,
but in practice, they are also used as yield-kickers.

Where there are risks, there are derivatives to strip the risk and transfer it. As
derivatives are essentially devices of transferring risks, their types and applications
differ based on the type of risk facing a business. Take, for instance, the following
sources of risk and the derivatives to protect a business against such risks:

Interest rate risk:

Banks and financial institutions face the risk of changes in interest rates. If a bank has
liabilities carrying floating costs and assets having fixed rates, it faces the risk of an
adverse movement, that is, a decline in interest rates. This risk can be sheltered by
writing an interest rate swap - that is, swapping the floating rate for fixed rates.

Associated with interest rate movements is the basis risk, that is risk of unpredicted
changes in the basis on which interest rates float. Let us say, a business has loans
which are floating with reference to the LIBOR or EURIBOR, whereas the assets of
the business are floating with reference to US treasuries. To cushion against this risk,
the business may like to swap the basis by entering into a basis swap.

Foreign exchange risk:

If a business has assets or liabilities denominated in foreign currency, there is a risk of

adverse changes in exchange rates. This risk is sheltered by foreign exchange futures
or forward covers.

Commodity risks:

A business having any position on commodities faces risk of changes in commodity

prices. Such risks are also sheltered by futures and forwards in commodities.
Risk on capital market instruments:

If someone holds equity shares, there is a risk that prices of equity shares will move
up or down. To manage this risk, there are various futures and options available.

Credit risk:

Yet another risk in all financial transactions is credit risk. Credit derivatives are used
to hedge against credit risk.

Weather risk:

Even something like risk of changes in weather is hedged and transferred. There is a
variety of weather derivatives, that is, instruments that pay off based on weather
changes.

Definition of a derivative:

Accounting standard SFAS 133 defines a derivative thus:

A derivative instrument is a financial instrument or other contract with

all three of the following characteristics:

a . It has (1) one or more underlyings, and (2) one or more notional
amounts or payment provisions or both. Those terms determine the
amount of the settlement or settlements... and in some cases, whether or
not a settlement is required.

b. It requires no initial net investment or an initial net investment that is

smaller than would be required for other types of contracts that would be
expected to have a similar response to changes in market factors.

c . Its terms require or permit net settlement, it can readily be settled net
by a means outside the contract, or it provides for delivery of an asset
that puts the recipient in a position not substantially different from net
settlement

Types of derivatives:

The following are the basic types of derivatives:

Forwards:

A forward is a contract to buy a thing or security at a prefixed future date. The typical
usage of a forward would be something like this: a business having its assets in a local
currency has taken a loan repayable in a foreign currency 6 months hence. There is an
exchange rate risk here: if the local currency suffers against the foreign currency, the
business has to write a loss. To cover against this risk, the business enters into a
forward contract - that is, it agrees today to buy the foreign currency 6 months hence
at prices prevailing today, against a pre-fixed premium. Obviously, if the perceptions
of the seller and the buyer as to future prices of the foreign currency differ, both will
strike what they perceive is a win-win deal.

Forwards are also quite common in commodities, and can be used either for
speculation or for hedging. Say, XYZ has an order to ship 10000 tons of steel 6
months hence at a prefixed price of say USD 1000 per ton (by the way, I have no idea
of steel prices, this is just an example!). And XYZ expects the price of steel to go up.
So, to hedge against the price risk, XYZ enters into a forward purchase agreement, for
10000 tons 6 months hence. XYZ's position is now fully hedged: if the price of steel
goes up as expected, XYZ will either claim a delivery from the forward seller, or a net
settlement. If the price comes down, XYZ will be obliged to settle by making a
payment for the price difference to the forward seller, but will be fully offset by the
pre-fixed price it gets from its own forward sale contract.

Futures:

Futures are more standardised forms of forward contracts and mostly operate in
organised markets. While it is possible to have a forward contract for any commercial
transaction, futures are normally exchange-traded. Futures contracts are highly
uniform contracts that specify the quantity and quality of the good that can be
delivered, the delivery date(s), the method for closing the contract, and the
permissible minimum and maximum price fluctuations permitted in a trading day.

Distinction between forwards and futures:

The basic nature of a forward and future, in a strict legal sense, is the same, with the
difference that futures are market-driven organised transactions. As they are
exchange-traded, the counterparty in a futures transaction is the exchange. On the
other hand, a forward is mostly an over-the-counter transaction and the counterparty is
the contracting party. To maintain the stability of organised markets, market-based
futures transactions are subject to margin requirements, not applicable to OTC
forwards. Futures market are normally marked to market on a settlement day, which
could even be daily, whereas forward contracts are settled only at the end of the
contract. So the element of credit risk is far higher in case of forward contracts.

Options:

The significant difference between a future and an option is that the option provides
the contracting parties only an option, not an obligation, to buy or sell a financial
instrument or security at a pre-fixed price, called the strike price. Obviously, the
option buyer will exercise the option only when he is in the money, that is, he gains
by exercising the option.

For example, suppose X holding a security of USD 1000 buys an option to put the
security at its current price with Y. Now if the price of the security goes down to USD
900. X may exercise the option of selling the security to Y at the agreed price of USD
1000 and protect against the loss on account of decline in the market value. If, on the
other hand, the price of the security goes upto USD 1100, X is out of the money and
does not gain by exercising the option to sell the security at a price of USD 1000 as
agreed. Hence, X will not exercise the option. In other words, the option buyer can
only get paid and does not stand to a position of loss.

Had this been a futures contract or forward contract, Y could have compelled X to sell
the security for the agreed price of USD 1000 in either case. That is to say, while a
future contract can result into both a loss and a profit, an option can only result into a
profit, and not a loss.

Two basic types of options are: call options and put options. A call option is an

option to call, that is, acquire a particular quantity and/or at particular strike price. A
put option is just the reverse- the option to put or sell a particular quantity and/or at a
particular strike price.

Swaps:

In a swap, both the parties exchange recurring payments with the idea of exchanging
one stream of payments for another. A typical usage is a swap of fixed interest rates
with floating rates, or rates floating with reference to one basis to another basis. In
credit derivatives market, there are swaps based on the total return from a particular
credit asset against total return on a reference asset.

Caps, floor and collars

Caps, floors and collars are essentially options designed to shift the risk of an upward
and/or downward movement in variables such as interest rates. These are normally
linked to a notional amount and a reference rate.

For example, if some one wants to transfer the risk of interest rates going up, one will
enter into a cap on a notional amount of say, USD 100 million, with the interest rate
of 5.5%. Now if the interest rate increases to 6%, the cap holder will be able to claim
a settlement from the cap seller, for the differential rate of 0.5% on the notional
amount. If the interest does not go up, or rather declines, the option holder would have
paid the premium, and there is no settlement.

On the other hand, if some one expects the interest rate to go down which spells a risk
to him, he would enter into a floor, which would allow him to claim a settlement if the
interest rate falls below a particular strike rate.

Interest rate collar is the fixation of both a cap and floor, so that the payment will be
triggered if the rate goes above the collar and below the floor.

Swaption:

A swaption is an option on a swap. The option provides the holder with the right to
enter into a swap at a specified future date at specified terms. This derivative has
characteristics of an option and a swap.

Symmetric and asymmetric returns:

A return from a contract or investment is said to be symmetric when it can either give
a profit or incur a loss.

Returns from forwards and futures are symmetrical: if you enter into a forward at a
particular price, the price might either go up or come down, and so, you might either
make a profit or a loss.

However, options have an asymmetric return profile: an option is an option with one
party. The option will be exercised only when the purchaser of the option is in-the-
money. Therefore, the only loss in an option is the cost of writing and carrying the
option. Hence, options have an asymmetric return profile.

On the other hand, the option-seller only makes returns by way of fees or premium for
selling the option, against which he takes the risk of being out-of-money. If the option
is not exercised, he makes his fees, but if the option is exercised, he might lose
substantially.