OTC derivatives

Nowadays, when you turn on CNN, CNBC or reading the news on the internet, the chances are you will hear something about TARP and the bank stress tests. You may also hear about CDO, CDS etc. These financial products certainly get some bad representation. Let's try to get some basics of what they are and some of their properties.

OTC and Derivatives
The common exchange-traded financial products, like stocks, bonds, futures, currencies are traded through an broker via an exchange. The type of an exchange can be physical (e.g. part of NYSE) or electronic (e.g. NASDAQ). One of the main advantage for using an exchange is to eliminate counter-party risks. It also improves market liquidity.

When we have an over-the-counter (OTC) contract, it is purely between 2 parties. Broker A can sell a contract tracking the performance of one or more financial products to Client B. They are binded by the terms of the legal agreement. Because of this counter-party risk, there is always the need of collateral. Periodic mark-to-market and contract resets are also used to determine if there is any need of additional collateral postings.

Derivative is a general term that say a product is traded based on some other underlying product(s), or it's value is derived from some product(s). A call option on IBM is a derivative that is derived from IBM. Futures and Swaps are some other example derivatives.

Similar to exchange-traded derivatives, OTC derivatives can be used to speculate or hedge. The leverage ratio of these contracts can also vary. The buyer may not need to come up with all the principles for the contract, the seller can determine what risk it is willing to take and only require a percentage to be posted as collateral.

It is how a company uses these financial instruments that makes them risky. For example, if a company buys a Credit Default Swap (CDS) to hedge the chance of a company default event for one for their junk bond holding, it will stabilize its portfolio. Of course, now they have to think about if they want to hedge the default risk of the counter-party writing the CDS.

Integrated Reporting of OTC Derivatives
There are lots of non-standard attributes for different OTC Derivatives products. If we understand what some of the key attributes and their meanings are, we can design our processing flows accordingly. I am not going to cover all the different attributes here, but would like to point out that there are usually 3 main components. The "exposure" part, the "interest" part, and the "collateral" part. In contrasts, the exchange-traded products usually only contain the "exposure" attributes.

For example, if we do not need the collateral and interest rate information on the OTC derivatives for some custody or accounting reports, they can be optional attributes for those applications.