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What is an OTC Derivative?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 05 October 2019
  • Copyright Protected:
    2003-2019
    Conjecture Corporation
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An over-the-counter derivative, also known simply as an OTC derivative, is a type of financial investment that is bought or sold outside the usual markets and exchanges. In some cases, the transactions occur directly between the buyer and the seller, with no intermediary involved. Since a derivative can be classed as any type of investment that is based on the value of underlying assets, this type of opportunity may be in the form of an agreement that grants the buyer the ability to purchase shares at a pre-determined price at some point in the future. The key is that buyers of over-the-counter derivatives are not bound to the purchase and can choose to not exercise the option to buy if the underlying shares do not perform as anticipated.

One of the benefits of an OTC derivative is the opportunity to quietly engage in this type of trading without calling a great deal of attention to the activity. Since the trades are taking place outside the market, the chances of the deal having much of an impact in that market is very limited. This makes investment in the derivatives a good option for investors who prefer to not call attention to themselves or to whatever strategy they have in mind for earning a profit from the deal.

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Another benefit of the OTC derivative is that since the deal takes place outside the market and does not necessarily have to involve an intermediary like a broker or a dealer, there is a good chance that the transaction can be managed without the payment of much in the way of fees. Assuming that the securities underlying the derivative ultimately perform as the buyer anticipates and the option to purchase is exercised, this means that the new owner gets to keep more of the returns rather than paying fees out of those returns. Even when the OTC derivative deal is created with the aid of a dealer network, the cost in terms of fees and charges is often less than with transactions conducted in the market.

As with any type of derivative, there is some degree of risk associated with the OTC derivative. In the event that the underlying shares do not produce the desired result, the investor may have lost valuable time that could have been spent on other investments. Fortunately, the degree of loss is kept to a minimum, since the investor can simply choose to not exercise the option to buy and prevent incurring any loss of the initial investment. This does tend to offer some benefit above and beyond other investment approaches in terms of generating returns.

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