What are Over the Counter (OTC) Options?

OTC options are customised derivatives contracts privately negotiated between two counterparties rather than traded through a standardised exchange. OTC options allow institutions, corporations, and other eligible parties to choose the strike prices, expiry dates, and contract details based on their requirements.

OTC market in India is legal and operated within the guidelines of the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI).

This comprehensive guide explains what over-the-counter options are, their objectives, types, pricing mechanisms, benefits, and risks.

What are Over-the-Counter (OTC) options?

OTC options stand for over-the-counter options, derivative contracts privately negotiated between two counterparties outside a recognised stock exchange. The parties agree on the terms of the contracts based on the specific business requirements.

The terms of the contracts can include the underlying asset, contract size, pricing, settlement mechanism, premium and collateral arrangements.

The concept of an option remains the same. An option gives the buyer the right but not the obligation to buy or sell the underlying asset at an agreed price, while the option seller has the obligation to fulfil the terms of the contract.

Depending on the contract, an OTC option can be structured as a call or put option and may include customised features not available in exchange-traded contracts.

In India, the OTC options market is relevant to eligible institutional participants and businesses managing exposure to interest rates, foreign exchange, commodities, and fixed-income instruments. The availability and permissible use of specific OTC derivatives depend on applicable regulatory frameworks and the type of market participant involved.

Read More: What are Forward Contracts?

Objective of OTC Options

The core objective of OTC options is to provide flexibility in structuring contracts to meet counterparties' specific requirements, subject to applicable regulations. This flexibility usually allows market participants to manage specific exposures and risks.

Here are the main objectives:

• Hedging:

Businesses can use customised options to protect against adverse price movements in currencies, interest rates, commodities or underlying assets.

• Customisation:

Contract terms can be negotiated to meet the participant’s required amount, strike price and settlement conditions.

• Risk Management:

Institutions can structure derivatives to manage specific financial risks arising from their business activities or other exposures.

• Cost Considerations

A mutually agreed-upon agreement may help avoid paying for features that are not required, but the overall cost of an OTC transaction depends on its terms, pricing, liquidity and other factors.

Types of OTC Options

OTC derivatives can be categorised based on the underlying or reference asset. The following are common categories relevant to OTC markets:

Based on the underlying assets from which value is derived, OTC options can be categorised into six main types:

OTC Interest Rate Derivatives

Interest rate derivatives are contracts whose value depends on movements in interest rates. OTC interest rate options can help financial institutions and businesses manage uncertainty in borrowing or investment costs.

Examples of interest rate derivatives include swaps, floors, and caps. These instruments can be customised according to the notional amount, maturity, benchmark and payment structure.

These OTC contracts may be useful when a participant has a specific interest-rate exposure that exchange-traded products cannot match.

OTC Commodity Derivatives

Commodity derivatives are linked to physical commodities such as crude oil, natural gas, metals, and agricultural products. OTC commodity options usually allow businesses to negotiate contracts based on their specific quantities, delivery periods, commodity grades, and pricing requirements.

Manufacturers, producers, importers and exporters may use such derivatives to manage commodity price uncertainty. Customisation can make OTC contracts useful when exchange-traded contracts do not match the physical exposure, delivery schedule or commercial requirements.

OTC Equity Derivatives

Equity derivatives contracts are linked to stocks and indices. OTC equity options may be structured for hedging institutional investment portfolios and customised exposure management, subject to applicable regulations.

OTC Forex Derivatives

Forex derivatives are linked to movements in currency exchange rates. OTC forex options are associated with businesses and institutions that have foreign currency receivables, payables or investment exposure.

Example: An exporter may use an OTC currency option to manage the risk of adverse exchange rate movements while retaining some benefit from favourable movements.

Fixed Income Derivatives

Fixed-income derivatives are linked to bonds, government securities, interest rates, or other fixed-income instruments. OTC structures help institutions manage duration, yield and interest rate risk associated with their portfolios.

These contracts can be customised according to maturity, notional value, underlying security and settlement requirements.

OTC Credit Derivatives

Credit derivatives are financial contracts designed to transfer or manage credit risk associated with a borrower, issuer or debt instrument. Credit default swaps are one type of credit derivative contract that can help institutions manage their exposure to credit default.

The underlying reference entity, notional amount, maturity, and settlement terms can be negotiated privately between counterparties.

Features of OTC Options

Here are key features of over-the-counter options:

• Negotiated Strike Price and Expiry:

In OTC options, both parties may negotiate the strike price and expiration date by mutual agreement, subject to applicable regulations.

• Direct Negotiation:

The two counterparties negotiate the commercial and contractual terms rather than accepting the terms of exchange-traded options.

• Customisable:

The most important feature of OTC options is the ability to customise the contract size, expiry date, underlying asset, and settlement terms.

• Less Public Transparency:

OTC transactions do not provide continuous public price visibility comparable to that available for exchange-traded contracts, making independent valuation and documentation important.

• Option Settlement:

OTC contracts are usually settled by cash payment or physical delivery, depending on the contract terms and applicable regulatory requirements.

• Limited Secondary-Market Liquidity:

OTC options generally lack the same standardised secondary market as exchange-traded options. Exiting or restructuring a position may depend on the availability and willingness of a counterparty to transact. To offset leverage losses and gains, the parties will need to enter into additional transactions to establish lines of credit with counterparties.

OTC Options vs Exchange-Traded Options

The major difference is that exchange-traded options follow standardised contract specifications determined by the exchanges. At the same time, OTC options are negotiated between two counterparties.

Here are the other key differences shown in a table below:

How Are OTC Options Priced?

The price of an OTC option depends on several variables, including the value of the underlying asset, the strike price, maturity, interest rates, expected volatility, and other contractual features.

For customised contracts, valuations may require financial models and market data rather than relying on an exchange quotation.

Independent valuation may be important for sophisticated OTC option contracts. Participants should understand the assumptions behind the valuation models and the market inputs used to calculate the contract’s fair value.

Benefits of Trading OTC Options

Here are several benefits of OTC options:

• Customised Hedging:

OTC option contracts allow businesses and institutions to structure protection around their actual exposure rather than adapting to a standard exchange contract.

• Flexible Maturity:

The participants can negotiate and agree on maturity dates that suit their cash flows, liabilities, or investment horizon.

• Tailored Payoffs:

Complex payoff structures can be designed to address specialised financial objectives and risk exposures.

• Strategic Risk Management:

Financial institutions and businesses can combine OTC options with other derivatives to construct broader risk management strategies.

• Exposure Matching:

Contract size and underlying characteristics can be aligned closely with a participant’s specific exposure.

Risk Involved in OTC Options

Here are the major risks associated with OTC options:

• Counterparty Risk:

The buyer or seller may face losses if either party fails to fulfil the contractual obligation. This is a key risk in the OTC market because there is no exchange involvement in settlement.

• Liquidity Risk:

An OTC option position may be difficult or expensive to terminate because no other counterparty may be willing to accept the contract. Therefore, it may be difficult or costly to exit the OTC trade in unfavourable scenarios.

• Pricing Risk:

In OTC options, public price discovery is limited. Here, prices are determined by independent valuations, which increases the risk of price fluctuations.

• Market Risk:

Changes in interest rates, exchange rates, commodity prices, equity values or volatility can adversely affect the option position.

• Legal and Operational Risk:

Any mistake in documentation, settlement procedures, valuation process or contractual interpretation increases the risk of unexpected financial losses.

Factors to Consider Before Trading OTC Options

Here are some important factors to consider when evaluating OTC options:

• Regulatory Framework:

Before entering an OTC trade, confirm that the proposed OTC derivative is permitted for the participant and the transaction under the applicable Indian regulatory framework.

• Counterparty Quality:

Assessing the counterparty’s financial strength, creditworthiness, reputation and ability to meet the contractual obligations throughout the transaction can be relevant to evaluating counterparty risk.

• Contract Terms:

Review the underlying asset, strike price, maturity, notional amount, premium, settlement process, collateral, and termination provisions.

• Valuation Method:

Understand option pricing because it depends on several variables, including the value of the underlying asset, strike price, maturity, interest rates, and other factors.

• Liquidity:

Evaluate whether the position can be closed, transferred or restructured if the original risk exposure changes unexpectedly.

• Risk Capacity:

Determine whether the potential losses, collateral requirements and cash flow obligations are consistent with the participant's financial position.

FAQs

• What are OTC options?

OTC options are derivative contracts which are traded outside regulated exchanges. In this, two parties privately negotiate the contract details, maturity dates and settlement method to hedge the business risk.

• Is OTC trading legal in India?

Yes, OTC trading is completely legal in India, but it is regulated by entities such as SEBI and RBI. Participants are usually institutions or corporations operating within guidelines set by the authorities.

• Are OTC stocks safe?

OTC stocks are a little risky because they are not listed on major exchanges and often have limited disclosure requirements. It is important to carefully analyse OTC stocks due to less transparency and reduced regulatory oversight.

• How to purchase OTC options?

OTC options are commonly used by financial institutions and businesses and are purchased through financial institution intermediaries. These types of options are less accessible to retail investors.

• What are OTC derivatives? Give an example

OTC derivatives include currency swaps, interest rate swaps, and forward agreements. Financial institutions and corporations commonly use these instruments for risk management.