What are OTC Derivatives?
- 23rd July 2025
- 11:30:00 AM
- 6 min read
Do you know that you can directly trade derivatives with a party without any regulated marketplace or any third-party involvement? Financial trades, such as over-the-counter derivatives or OTC derivatives, often occur off the books.
As the number of derivatives investors in India has increased to 96 lakh in FY25, most of the investors use the exchange-traded instruments. Therefore, you must know how OTC derivatives work and how it is different from exchange-traded instruments.
This blog provides the conceptual clarity of OTC derivatives meaning, and their associated risks.
What are OTC Derivatives?
Over-the-counter derivatives are transactions that allow the exchange of derivative instruments based on the price of a security, the price of a foreign currency, a precious metal, or an interest rate.
These financial deals take place directly between two parties without using a regulated marketplace. However, the biggest concern of using OTC derivatives is their credit risk. OTC derivatives do not provide an extra layer of protection like regular deals.
6 Different Types of OTC Derivatives
You must be familiar with different types of over-the-counter derivatives to be an experienced investor and generate earnings. Here are the different types of OTC derivatives that you can trade:
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Credit Derivatives
Credit derivatives enable investors or businesses to transfer the credit risk of an underlying asset to a third party, without actually exchanging the asset itself. These financial instruments act as a safety net, helping manage uncertainties such as the risk of default or delayed payments from borrowers.
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Interest Rate Derivatives
This type of OTC derivative derives its value from interest rates, interest rate instruments, or interest rate indices. For instance, swaps are the most common type of interest rate derivatives in the OTC market. It enables the exchange of cash flows depending on various interest rates.
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Forward Derivatives
Forward contracts are common OTC derivatives that are traded between two parties. It uses an agreement to trade an underlying asset at a predetermined price and on a future date. Businesses use these forward contracts to protect themselves from unpredictable price swings and bet on future prices.
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Swap Derivatives
Swap derivatives are agreements that allow for the exchange of cash flows on a prearranged formula. These OTC derivatives help to manage risks from interest rates, commodity prices, and currency fluctuations. As a result, you can adjust your positions based on the movements of interest rates and currency fluctuations.
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Options Derivatives
Options derivatives give you the right but not the obligation to buy or sell an asset at a predetermined price and on a particular future date. There are two strategies of options derivatives, which are call options and put options. While call options give you the right to buy, put options allow you to sell an asset.
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Commodity Derivatives
A commodity derivative contract allows you to trade on the price of an underlying commodity, including agricultural and non-agricultural goods. You can protect yourself from changes in the price of certain commodities by using these OTC derivatives contracts.
4 Key Benefits of OTC Derivatives
Here are some benefits of using over-the-counter derivatives:
- The main benefit of these OTC derivatives is the flexibility they offer as a private contract. You can customise these contracts according to your risk tolerance and return requirement.
- You can use these OTC derivatives for commercial operations like leverage, hedging, and risk transfer.
- Since businesses are exempt from the standardised standards about exchange-traded derivatives, it may provide more flexibility. They can design agreements that meet their financial objectives.
- You can trade OTC derivatives at a lower cost compared to exchange-traded instruments. It also involves fewer regulatory hurdles, which helps you to make streamlined financial transactions.
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Limitations of OTC Derivatives
While there are numerous benefits of OTC derivatives, you should also become aware of the limitations. Here are some limitations of trading OTC derivatives:
- There is no central system to clear and settle the transactions. Each OTC contract has the risk of credit or default.
- These contracts also involve liquidity risks as they depend on the availability of buyers. Lack of market interest in buyers can lead to an illiquid situation.
- OTC contracts are speculative by nature. They may compromise market integrity and force traders to incur losses.
What are the Associated Risks That Can Be Managed Using OTC Derivatives?
You can manage numerous risks using OTC derivatives. Some of them are:
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Currency Risk
Currency risk is one of the primary risks that you can manage using these contracts. OTC derivatives allow you to protect yourself from currency rate volatility by fixing or locking the exchange rate. OTC currency derivatives are mainly beneficial for import and export businesses.
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Interest Rate Risk
By using an interest rate swap with another trading party, you can fix the interest rate and avoid fluctuations.
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Commodity Price Risk
You can manage the commodity price risks by locking a commodity’s future selling price.
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Final Thoughts
Over-the-counter derivatives are confidential contracts made between parties outside of stock exchanges. Since the conditions are negotiated and customised to meet the needs of both parties, it offers greater flexibility. Before you start trading in OTC derivatives, you must have a clear understanding of them.
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Frequently Asked Questions
1. Which over-the-counter derivatives are most common?
Swaps are the most common OTC derivatives. It involves the exchange of cash flow based on an underlying asset.
2. How are OTCs different from listed options?
Listed options are traded on a formal exchange, like exchange-traded option contracts. Contrarily, OTC options are exotic options that are traded in the over-the-counter market.
3. Are futures contracts the same as OTC derivatives?
No, futures contracts are not the same as OTC derivatives. Futures are standardised financial contracts that are traded on regulated exchanges. On the other hand, OTC derivatives are traded off the books without any involvement of regulated exchanges.
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Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.
