Accounting for Investments, Volume 2: Fixed Income Securities and Interest Rate Derivatives—A Practitioner's Guide

OVER-THE-COUNTER CONTRACTS

Over-the-counter (OTC) derivatives are contracts that are traded directly between two parties, without going through an exchange or other intermediary. These are privately negotiated trades and the terms are structured in such a way to suit the parties involved in the trade. Interest rate swaps, forward rate agreements, and other exotic options are usually traded as over-the-counter derivatives. The OTC derivative market is the largest market for derivatives and is largely unregulated when it comes to disclosure of information between the parties. The predominant players in this market segment are banks and other less regulated entities like hedge funds. Reporting of OTC contracts is difficult because trades often occur privately between the counterparties and as such are not recorded on any exchange.

As OTC derivatives are not traded on an exchange, there is no central counterparty and this means that the contracts suffer from counterparty risk, like any other private contract between two parties where each one of them relies on the other to perform the contract. The counterparty risk faced by a derivatives trader is often in the form of replacement risk.

As per the market survey results provided by the International Swaps and Derivatives Association (ISDA), the notional amount outstanding of interest rate derivatives (IRD) was at US$426.75 trillion at the end of Dec 2009.