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Over-the-counter (OTC) derivatives are financial contracts traded directly between two parties without going through an exchange. They can be customized to meet the specific needs of the counterparties. Here’s a list of common types, categorized broadly as public and private, although the distinction isn’t always clear-cut as some “private” deals can be referenced in public filings or involve publicly listed companies.
Publicly Referenced OTC Derivatives:
These are types of OTC derivatives that are widely discussed in financial markets, often have standardized forms (though still traded privately), and their aggregate volumes and activities are tracked by regulatory bodies and market data providers.
* Interest Rate Swaps (IRS): Agreements to exchange interest rate payments based on a notional principal. For example, a company might swap its floating rate debt for a fixed rate to hedge against interest rate increases.
* Currency Swaps: Agreements to exchange principal and/or interest payments in one currency for equivalent payments in another currency. Multinational corporations use these to manage foreign exchange risk.
* Credit Default Swaps (CDS): Contracts that provide insurance against the default of a specific company or country. Buyers pay a premium to the seller, who agrees to compensate the buyer if a credit event occurs.
* Equity Swaps: Agreements to exchange cash flows based on the return of an equity or a basket of equities against another type of return, such as a fixed rate or a floating interest rate.
* Commodity Swaps: Agreements to exchange cash flows based on the price of a commodity (e.g., oil, natural gas, gold) against a fixed price or another floating rate. Airlines might use fuel swaps to hedge against rising jet fuel costs.
* Foreign Exchange Forwards (FX Forwards): Customized agreements to buy or sell a specific amount of currency at a predetermined exchange rate on a future date. Companies involved in international trade use these to lock in exchange rates.
* Options (OTC Options): Customized option contracts (call or put) on various underlying assets (currencies, interest rates, commodities, equities). These give the buyer the right, but not the obligation, to buy or sell the asset at a specific price on or before a certain date.
Privately Negotiated OTC Derivatives:
These are often more complex, highly customized, and less transparent derivatives tailored to the specific and unique needs of the counterparties. Information about these trades is usually not publicly disclosed.
* Exotic Options: These are options with non-standard features, payouts, or underlying assets compared to vanilla options traded on exchanges or in more standardized OTC markets. Examples include barrier options, binary options, and lookback options.
* Structured Notes: Debt instruments with embedded derivative components designed to provide specific payoff profiles linked to the performance of an underlying asset or index. These can be highly customized to an investor’s risk and return preferences.
* Swaptions: Options on swaps, giving the buyer the right, but not the obligation, to enter into a swap agreement at a specified future date.
* Variance Swaps: Contracts where the payoff is based on the realized variance of an underlying asset’s returns over a specified period. These are used by sophisticated investors to trade volatility.
* Correlation Swaps: Their payoff depends on the correlation between the returns of two or more assets. Hedge funds might use these to express views on market co-movements.
* Basket Options: Options linked to the performance of a specific portfolio or “basket” of underlying assets.
* Contingent Convertibles (CoCos): While technically debt instruments, CoCos have features that trigger conversion to equity or write-downs based on certain capital thresholds, effectively embedding a complex derivative-like element. These are often specific to financial institutions.
* Forward Rate Agreements (FRAs): Agreements to lock in an interest rate for a future period on a notional principal. While relatively common, the specific terms are privately negotiated.
* Total Return Swaps: One party pays the total return of an asset (including income and capital gains) to another party in exchange for a fixed or floating rate.
Important Considerations:
* Transparency: Publicly referenced OTC derivatives generally have more transparency in terms of pricing and trading volumes (though still less than exchange-traded derivatives). Privately negotiated ones are significantly less transparent.
* Standardization: Publicly referenced OTC derivatives often have some level of standardization in their terms, facilitated by industry bodies like ISDA (International Swaps and Derivatives Association). Private ones are highly customized.
* Regulation: Following the 2008 financial crisis, there has been a push to increase regulation and transparency in OTC derivative markets, including mandatory clearing and reporting for certain standardized contracts. This has blurred the lines somewhat between “public” and “private” in terms of regulatory oversight.
* Counterparty Risk: All OTC derivatives carry counterparty risk (the risk that the other party to the contract will default). This risk is generally higher with privately negotiated and less standardized contracts, especially those traded between less regulated entities.
This list provides a general overview. The world of OTC derivatives is vast and constantly evolving, with new types of customized contracts being created to meet specific hedging or investment needs.