Definition
OTC derivatives are privately negotiated between counterparties, offering customization not available on exchanges. This flexibility comes at the cost of counterparty risk, lower transparency, and reduced liquidity. Major OTC markets include interest rate swaps, FX forwards, CDS, and exotic options. Post-2008 regulations pushed many standardized OTC derivatives toward central clearing.
lightbulb Example
A multinational negotiates a bespoke 7-year currency swap with its bank to hedge CAD/USD exposure from a Canadian subsidiary. The exact notional, amortization schedule, and dates are customized to match the company's actual cash flows.
verified_user Key Points
- Privately negotiated—highly customizable
- Counterparty risk is the primary concern
- Includes swaps, forwards, exotic options
- Post-2008: standardized OTC trades must be centrally cleared