Educational Pack · 14
Over-the-Counter Derivatives
Source PDF: GUIDE-TO-UNDERSTANDING-ASSET-CLASSES-OVER-THE-COUNTER-OTC-DERIVATIVES.pdf
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What are derivatives?
A derivative is a security whose price is dependent on, or derived from, one or more underlying asset. The derivative itself is merely a contract between two or more parties.
There is a crucial difference between a direct investment and an investment in a derivative:
- when directly investing in a financial instrument such as a stock or a bond, the investor participates directly in its risks, gains, and losses.
- when investing in a derivative, the investor invests in a contract, note, unit, or certificate. This adds specific characteristics, risks, obligations, and/or rights to the assets on which the derivative is based.
An underlying can consist of a single asset or multiple assets. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indices.
The value of the derivative depends in a non-linear way on the price of its underlying.
A derivative may be traded over the counter (unlisted) or be standardised and traded on public exchanges.
Advantages / disadvantages
Advantages
- Cost efficiency by leverage: the gross amount invested is smaller than trading the individual underlyings.
- Hedging instruments: losses can be limited by long options (buying a right).
- Flexibility: ability to trade a wide range of underlyings and to lock in prices.
Disadvantages
- Options have a 'time decay'; the time value of the option decreases over the investment period.
- They can have higher spreads and commissions per dollar invested.
- If used with a speculative intention, strategies such as leverage and short selling bear the risk of overproportional or even unlimited losses.
- Over-the-counter derivatives carry additional risks such as counterparty risk and higher liquidity risks that do not apply to standardised exchangetraded options.
Important risks to consider — OTC derivatives
| Risk | Description |
|---|---|
| Price risks | The price of the underlying, the volatility of the price, and the time to expiration of the option. These are the most important ones. |
| Market risks | The price of the underlying, a major factor influencing the price and pay-off of the option, is subject to market risks. |
| Leverage | When investing in derivatives, minor investment amounts can control much larger volumes. This is called 'leverage'. If the market falls, leverage maximises risks, as well as gains, from the investments. |
| Over-the-counter derivatives | Over-the-counter traded derivatives may carry additional risks such as counterparty risk and higher liquidity risks than exchange-traded standardised options. |
The following two pages explain a number of common OTC options and a selection of option strategies.
OTC derivatives, examples of OTC options
| Option | Description |
|---|---|
| Vanilla OTC option | The term ‘vanilla’ refers to normal OTC options without any kind of special features such as barriers. In contrast to exchange-traded options, vanilla OTC options are not standardised when it comes to underlyings, strike prices, contract sizes, or expiry dates. |
| Barrier option | Barrier options are path-dependent options. On top of the strike price, they contain a barrier price. There are two different kinds of barrier options: knock-in and knock-out options. Knock-in option: the option only becomes active once the barrier price is breached. Knock-out option: the option becomes invalid as soon as the barrier price is breached. |
| Transatlantic barrier option (knock-in/knock-out) | A transatlantic barrier option contains two barriers. The first is a European-style barrier which is above the strike (in case of a call option; “up and in”). The second one is an American-style barrier which is equal to or below the strike price (in case of a call option; “down and out”). In the case of a put option, the American-style barrier is above and the European-style one is below the strike. |
| Digital-at-expiry option | Compared with a vanilla option, the digital-at-expiry option pays off the same amount, – independent of how far above the strike price the underlying asset closes (call option), or – independent of how far below the strike price the underlying asset closes (put option). |
| One touch/no touch | Compared with vanilla options, one-touch options allow to profit from a simple yes-or-no outcome. There are only two possible scenarios: – The strike price is reached → the investor receives the premium plus a defined payout; or – The strike price is not reached → the investor loses the option premium. |
OTC derivatives, selected option strategies
The following blocks describe different option strategies. Options strategies are combined buys and/or sells of call/put options at the same time on the same underlying.
Stradel / Strangle
A stradel is a strategy in which a call and a put are bought with the same expiration date and strike price. It can be used in case of high volatility but uncertain direction.
A strangle is a strategy in which a call and a put are bought with the same expiration date but different strike prices. It can be used if the investor has a clear view of the direction in which the underlying price moves but wants to be protected anyway.
Call/put spread
A call spread is a strategy in which a call at a specific strike price is bought and a call of a higher strike price is sold. It can be used in case a moderate rise in underlying asset price is expected.
A put spread uses the same strategy using puts in case of moderate declining asset prices.
Butterfly spread
A butterfly spread combines two call spreads. It involves four call options: a buy of a call option with a strike price below the current price; a buy of a call option with a strike price above the current price; and a sell of two call options with a strike price equal to the current price.
It can be used if the investor thinks the underlying asset will not move much.
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