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What are over-The-Counter Derivatives?

Jim B.
Jim B.

Over-the-counter derivatives are financial instruments that base their value on the value of some underlying financial instrument and are traded in the absence of a centralized exchange. Such instruments allow investors the ability to make profits without ever owning the physical assets underlying the investment. Some types of over-the-counter derivatives include futures, options, and foreign exchange trades. As these derivatives are not administered by an exchange, investors can have a difficult time making a valuation of their investment and have little recourse should a derivative contract not be honored.

Many individuals looking to make investments do so via the stock market, buying and selling shares of publicly traded companies and hoping to gain from the rising and falling values of those shares. For more ambitious investors, there are other financial instruments known as derivatives, which allow an investor to speculate on the movement of financial securities without actually gaining any physical possession of them. When these instruments are traded between investors with no centralized body recording and governing the trades, they are called over-the-counter derivatives.

Businessman with a briefcase
Businessman with a briefcase

As an example of an over-the-counter derivatives contract, imagine that an investor believes that the price of gold is going to rise in the near future. He can buy a futures contract to lock in the purchase of a certain amount of gold on some future date at a price agreed on by the seller. The investor must pay the seller for the contract, which would generally amount to a fraction of the current price for gold. If the price goes up, the value of the contract would rise along with it.

In this way, an investor can speculate on the movement of any underlying financial security and can do so at a discount from what it would cost him to buy the security itself. Along with the benefit of lower costs, over-the-counter derivatives offer investors the chance to gain profits in a relatively quick span of time. This is in contrast with stocks, which often require a long-term commitment to see the investment come to fruition.

There are, however, significant risks to over-the-counter derivatives that can offset the benefits. With any derivative, the possibility of significant loss in a short time is impossible to ignore. When such instruments are purchased over the counter, the investor lacks any evidence concerning the market's perception of their value. In addition, investors purchasing contracts to be executed at some point in the future run the risk of the contract's corresponding party failing to live up to its obligations.

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