OTC derivative
Also written Over-the-counter derivative · Over-the-counter (OTC) derivative · OTC derivatives · OTCD · OTC derivative (OTCD)
A non-standard derivative contract settled directly between counterparties on mutually agreed terms, relying on trust between them rather than on an exchange and clearing house.
In plain language
Some derivative contracts are agreed directly between two parties. They are not bought and sold on an exchange. These are over-the-counter (OTC) derivatives.
The workbook describes them this way:
- They are settled between the two sides on terms both sides agree.
- They are not standard.
- They rely on each side trusting the other to keep its promises.
- They are common only between institutions that are happy dealing with each other.
The opposite is the exchange-traded derivative. This is a standard contract set by an exchange. It is usually settled through a clearing house.
The workbook sums it up in one line: forwards are OTC derivatives; futures are exchange-traded derivatives.
How it works
How an OTC contract is built. In a forward, the parties negotiate price, quantity, quality, time and place; any alteration is possible if both agree (Chapter 5, section 5.2.1). Corporations, traders and investing institutions use OTC transactions to meet specific requirements.
OTC vs exchange-traded (Chapters 2 and 5):
| OTC derivative | Exchange-traded derivative | |
|---|---|---|
| Terms | Negotiated, tailor-made | Standardised by the exchange |
| Settlement | Directly between counterparties | Through a clearing corporation / house |
| Credit risk | Each counterparty manages it | Clearing corporation guarantees settlement (novation) |
| Participants | Institutions that know each other | Anonymous players, on the strength of margins |
| Examples in the workbook | Forwards, swaps, cross-currency swaps | Futures, exchange-traded options |
The limitations the workbook lists for forwards (section 5.2.1.1):
- Liquidity risk — tailor-made terms mean other participants may not want the contract; it is not listed.
- Counterparty (default/credit) risk — a party may walk away when it has an incentive to.
- Lack of transparency and settlement complications.
Futures were innovated to overcome these.
Governance of OTC markets. Swaps are OTC but governed by rules accepted by swap dealer associations; in India, the Fixed Income Market and Derivatives Association of India (FIMMDA) (as the workbook names it) is a voluntary market body for bond, money and derivatives markets (section 5.2.4).
A worked example
The workbook's rice example (section 5.2.1.1). A agrees to buy 100 kg of rice at ₹20 per kg from B after six months — a contract value of ₹2,000.
- If the market price rises to ₹30, B has an incentive to default: selling in the market brings 100 × ₹30 = ₹3,000, or ₹1,000 more than the contract.
- If the price falls to ₹15, A has an incentive to default: buying in the market costs 100 × ₹15 = ₹1,500, or ₹500 less than the contract.
No clearing house stands between them, so whichever side is losing may simply not perform.
An illustrative institutional version. An Indian importer agrees with its bank, bilaterally, to buy USD 1 million in three months at an agreed rate of ₹84.00 (an illustrative rate). The terms (amount, date) exactly match its payment — something a standard exchange contract might not do. But the importer is exposed to the bank's ability to pay, and neither side can easily exit early, because no one else trades that exact contract.
Why NISM asks about it
Chapter 5 (Derivatives) covers OTC derivatives in sections 5.2.1 (forwards), 5.2.1.1 (limitations), 5.2.4 (swaps and FIMMDA) and 5.3 (structure of derivative markets). Chapter 2 (section 2.2.2) contrasts OTC and exchange-traded markets, Chapter 17 notes that exchange-traded securities are more liquid than OTC ones, and Chapter 19 (section 19.5) describes forward contracts and cross-currency swaps as OTC. Chapter 5 (section 5.7) says portfolio managers may invest in derivatives through recognised stock exchanges.
Common exam traps
- Forwards are OTC; futures are exchange-traded. The workbook states this directly.
- In OTC markets, each counterparty bears the credit risk. Only in exchange-traded markets does the clearing corporation guarantee settlement.
- Swaps are OTC, even though they follow rules accepted by dealer associations such as FIMMDA.
- OTC contracts are less liquid, not more — they are tailor-made and unlisted.
- Portfolio managers' derivative investments are described in the workbook as made through recognised stock exchanges (section 5.7).
Where this is taught
- Series XXI-B · Chapter 5: Derivativesintroduced here
- Series V-D · Chapter 19: Interest Rate Derivativesintroduced here
- Series X-A · Chapter 10: Understanding Derivativesintroduced here
Related terms
- NovationThe clearing corporation stepping into the middle of every trade — becoming the buyer to every seller and the seller to every buyer — so that neither side carries the other's default risk.
- Clearing corporationThe entity that steps between every buyer and seller in the derivatives segment by novation, becoming the counterparty to both sides and guaranteeing that the trade settles.
- Currency swapAn OTC derivative in which two parties exchange streams of interest payments and/or principal in different currencies on set dates over the swap's life, at an exchange rate agreed at the start.
- Forward contractA bilateral, over-the-counter agreement between two parties to buy or sell an asset on a fixed future date at a price agreed today — customised to suit them, and binding on both.
- Futures contractA standardised forward traded on an exchange, where the exchange fixes every term except the price and the clearing corporation guarantees settlement, so neither side carries the other's default risk.
- Counterparty riskThe risk of an economic loss because the other party to a contract fails to fulfil its obligation — acute in forwards, and removed for exchange-traded derivatives by the clearing corporation's guarantee.
- Exchange traded derivativeA derivative traded on an organised exchange on standardised terms, with prices set by anonymous auction and performance guaranteed by a clearing corporation — as against a bilateral, customised OTC contract.
- Imperfect hedgeA hedge that cannot fully offset an exposure because the contract is standardised — fixed lot sizes, a fixed expiry date and cash settlement leave a remainder the hedger keeps.
- Interest Rate CapA series of interest rate call options, called caplets, that pays the buyer at the end of each period in which the underlying interest rate is above the strike rate agreed in advance.
- Interest Rate FloorA series of interest rate put options that pays the buyer at the end of each period in which the underlying interest rate is below the strike rate — protection against falling rates.
- Interest Rate CollarBuying an interest rate cap and selling an interest rate floor on the same rate, maturity and notional — capping borrowing cost from above while giving up the benefit of rates falling below the floor.
- Government Securities LendingLending a specific government security for a fee against the collateral of other government securities for a fixed period, under RBI's GSL Directions, 2023 — both securities are returned at the end.
- Bond forwardAn OTC rupee interest rate derivative in which a buyer agrees to buy a specific Government Security from a seller on a future date at a price fixed today — governed by RBI's Directions of 21 February 2025.
- Request for Quote (RFQ) platformThe exchange platform, launched in early 2020, on which participants seek and respond to quotes to execute and settle trades in debt securities, with an audit trail that brings pre-trade transparency to an OTC market.
- Reverse Interest Rate CollarBuying an interest rate floor and selling an interest rate cap on the same rate, maturity and notional — protecting a floating-rate receiver against falling rates while giving up gains above the cap.
- DerivativeA contract whose value is derived from the value of something else — the underlying — rather than from anything the contract itself owns or produces.
- Over-the-counterA bilateral market where two parties negotiate a contract's terms directly, with no exchange or clearing house between them, unlike a standardised, centrally cleared exchange-traded market.