Certificate in Alternative

Investment Industry
OTC Derivatives Module

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Alternative Investment Industry” elective course. SS&C GlobeOp reserves the right for any kind of copying, duplicating, reproducing and distributing of this
information.

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 Table of Contents

1. Overview of OTC Derivatives……….....................................................................................2

2. OTC Products and its variants…………………………………………………………………………………………… 4

3. Trade life Cycle ...................................................................................................................5

a. Trade Capture ........................................................................................................................................ 6
b. Confirmation of Trade ………................................................................................................................... 6
c. Reconciliations …….............................................................................................................................. 6
d. Collateral Management ...........................................................................................................................7

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 OTC DERIVATIVES MODULE

Overview -
In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market:
Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties,
without going through an exchange or other intermediary and Exchange Traded Derivatives (ETD) which are derivative
instruments traded on the exchanges.

A security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, etc. The phrase "over-the-
counter" can be used to refer to stocks that trade via a dealer network as opposed to on a centralized exchange. It also refers
to debt securities and other financial instruments such as derivatives, which are traded through a dealer network

 Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two
parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements,
exotic options – and other exotic derivatives – are almost always traded in this way. The OTC derivative market is the
largest market for derivatives, and had been largely unregulated with respect to disclosure of information between the
parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Recently
with the new regulations the OTC market place is more transparent than it has been ever.
 Exchange-traded derivatives (ETD) are those derivatives instruments that are traded via specialized derivatives
exchanges or other exchanges. A derivatives exchange is a market where an individual trades standardized contracts
that have been defined by the exchange.

Some common variants of OTC products are

 Swaps
 Options
 Forwards

 Options - Contracts that give the owner the right to buy or sell an asset, depending on the type of option.

a. Call Option – The buyer has a right to buy a certain quantity of the underlying asset, at a specified price (Strike) on or
before a given date in the future. He however is not obliged to exercise this right.
b. Put Option - The buyer of a Put option has the right to sell a certain quantity of an underlying asset, at a specified
price on or before a given date in the future. He however is not obliged to carry out this right.

To summarize –
Option Buyer's Right Seller's Obligation
Call To Buy To Sell
Put To Sell To Buy

Strike - The price at which the sale takes place is known as the Strike price and is specified at the time the parties enter into the
option. The option contract also specifies a maturity date.

European option - the owner has the right to require the sale to take place on but not before the maturity date

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American option - the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract
exercises this right, the counter-party has the obligation to carry out the transaction.

 Swaps: Swaps are contracts to exchange cash (flows) on or before a specified future date based on the
underlying value of currencies exchange rates, bonds/interest rates, stocks or other assets.
Swaps can basically be categorized into two types:

a. Interest rate swap: An exchange of interest associated cash flows in the same currency, between two parties.
b. Currency swap: This exchange of the cash flow between the two parties includes both principal and interest.
Also, the money which is being swapped is in different currency for both parties.
c. Credit Default Swap: A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will
compensate the buyer (the creditor of the reference loan) in the event of a loan default (by the debtor) or other
credit event. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in
exchange, receives a payoff if the loan defaults.
d. Equity swap: An exchange of cash flows between two parties that allows each party to diversify its income, while
still holding its original assets. The two sets of cash flows are exchanged as per the terms of the swap, which may
involve an equity-based cash flow (such as from a stock asset) that is traded for a fixed-income cash flow (such as a
benchmark rate) like LIBOR.
e. Swaption: An option on the forward Swap.
Swaption is of two kinds: Receiver Swaption and a Payer Swaption.
 Receiver Swaption - An option to receive fixed interest rate and pay floating interest rate
 Payer Swaption - An option to pay fixed and receive floating interest rate

Variants of OTC Derivatives Contracts

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OTC Trade Life Cycle

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OTC Trade Processing Flow
Each OTC trade goes through various stages until its maturity. While it goes through its various life cycle events namely,
Terminations, Assignments, etc there are specialists who ensure these trades are well kept and maintained in the company’s
books of records. They also ensure that all agreed obligations of the trade agreement are also honored.

Trade Capture – They maintain and are the gate keepers to the correct and complete trade flow to the trade order
management system and ultimately to the accounting engine.

Trade Confirmations – Prime responsibility of having the trade agreements signed by both the parties, after they are verified
and confirmed to be depicted by the trade booked in the systems. These trade agreements are governed by an authority
International Swaps and Derivatives Association.

Reconciliation – Trade and Cash

Trade Reconciliation engulfs the portfolio reconciliation which reconciles every trade detail with that of the counterparty and
ensures that ultimately each position with its every detail, ties out with that of the Counterparty.

Cash Reconciliation ensures all cash arising out of these trades are settled with the external counterparts in time accurately.
They shoulder the responsibility of all cash events including Corporate Actions, Resets, Swap Cashflows, Premium and Payoff
calculation and settlement with the counterparts.

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Collateral Management – They closely monitor the exposure of the trade portfolio daily and mitigate risk by encashing the
exposure in their favor on a daily basis. They shoulder the responsibility to ensure that at any given point in time, the risk of the
portfolio is mitigated, by calling back all cash posted as Margin/collateral security, when the trading portfolio is in their favor.
Likewise they would also pay the price of being exposed to the counterparty when the exposure is in counterparty’s favor.