A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indexes.
Depending on where derivatives trade, they can be classified as over-the-counter or listed. An over-the-counter derivative trades off major exchanges and can be tailored to each party's needs.
How Over-The-Counter Derivatives Work
Over-the-counter derivatives are private contracts between counterparties. Unlike over-the-counter derivatives, listed derivatives are more structured and standardized contracts in which the underlying assets, the quantity of the underlying assets and settlement are specified by the exchange.
Over-the-counter derivatives are private contracts that are traded between two parties without going through an exchange or other intermediaries. Therefore, over-the-counter derivatives could be negotiated and customized to suit the exact risk and return needed by each party. Although this type of derivative offers flexibility, it poses credit risk because there is no clearing corporation.
For example, a swaption is a type of over-the-counter derivative because it is not traded through exchanges.
What Is a Swaption?
A swaption (or swap option) is a type of derivative that grants the holder of the security the right to enter into an underlying swap. However, the holder of the swaption is not obligated to enter into the underlying swap.
There are two types of swaptions: a payer and a receiver.
- A payer swaption gives the owner the right to enter into a specified swap where the owner pays the fixed leg and receives the floating leg.
- A receiver swaption gives the owner the right to enter into a swap in which he receives the fixed leg and pays the floating leg.
The buyers and sellers of this over-the-counter derivative negotiate the price of the swaption, the length of the swaption period, the fixed interest rate, and the frequency at which the floating interest rate is observed.