Over-the-counter (OTC) derivatives are contracts that are traded between two parties privately. There are a number of kinds of OTC derivatives that are derived based on the requirements of the parties. In this Swap derivative and exotic derivative function are used.
Based on the inherent requirement of the company and their trading model they each devise their own form of derivatives. These are based on the requirements of the situation.
The reasons for the financial markets to use derivatives are that they reduce the risk involved in the process. Contracts that are formed in the financial markets are non-binding contracts. They are used to leverage returns of the products. Companies can use this strategy to develop and enter into complex arrangement. They are found to be of immense benefit for the companies and to the stakeholders involved in the companies. There are also some potential pitfalls that need to be watched out in the case of derivatives. It has been found that the derivatives are volatile investments (Bernanke, 2006). It has been found that the derivatives within the private investors allow the companies and the parties involved to change the terms of the contractual agreements. There is more control and autonomy of the processes of the companies that are involved.
Value of the derivative is based on the asset value of the products. In this case there is high probability for the products to loss it asset value if the pricing of the original security changes. This causes the derivative to lose its entire value. Owing to this the derivates are considered to be risky.