Friday, June 12, 2009

What are OTC derivatives?

A derivative is a financial product whose value is 'derived' from an underlying asset (hence the name). The underlying asset can be anything of value - stock of a company, an index like the S&P, or a commodity like gold, wheat or oil. Based on where they are traded, derivatives can be classified as OTC (Over the Counter) or Listed (trading on exchanges). OTC derivatives are private, tailor-made contracts between counterparties. Listed derivatives are more structured and comprise standardized contracts where the underlying assets, the quantities and the mode of settlement are defined by the exchange.

Since listed derivatives are backed by the full faith of the clearing house, they have been the 'traditional' instrument of choice for traders. But OTC derivatives are fast gaining in popularity. Being private contracts between two counterparties, OTC derivatives can be tailored and customized to suit exact risk and return needs. On the flip side, of course, lack of a clearing house or exchange results in increased credit or default risk associated with each OTC contract.

Presented below is a broad classification of different types of OTC contracts, based on the underlying asset or commodity that drives the value of the instrument.
  • Interest rate derivatives: The underlying asset is a standard interest rate e.g. the London Interbank offer rate, or the rate on US treasury bills. Examples of interest rate OTC derivatives include Swaps, Swaptions, and FRAs.
  • Credit derivatives: The underlying is the credit quality, risk or credit event of a particular asset or counterparty. One example is Credit Default Swaps (CDS) on fixed-income securities, which make payments if the underlying bonds are downgraded by credit rating agencies or if the company that issued the bonds defaults.
  • Commodity derivatives: The underlying are physical commodities like wheat or gold. Examples are forwards.
  • Equity derivatives: The underlying are equities or an equity index. Examples: Equity swaps or forwards
  • FX derivatives: The underlying is foreign exchange fluctuations.
  • Fixed Income: The underlying are fixed income products - including mortgages

Thursday, June 11, 2009

Vinod Jain


Vinod Jain is a Business Specialist in the Derivatives Domain Consulting Group at Headstrong. He specializes in business process, change management and IT consulting for middle office and back office derivatives processing. He has worked extensively with buy side and sell side firms in Europe and US. He has done consulting for Bank of America Merrill Lynch, Credit Suisse, New York Stock Exchange, Bank of New York Mellon etc. He analysis the industry trends and events through research and thought papers.