The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

OTC EQUITY DERIVATIVES

An OTC equity derivative can be delivered on a stand-alone basis or as part of a structured product. Structured products involve packaging standard or exotic options, equity swaps, or equity-linked debt into a single product in any combination to meet the risk–return objectives of the investor and may represent an alternative to the cash market even when cash instruments are available.

The four basic components of OTC equity derivatives are equity forwards, OTC options, equity swaps, and equity-linked debt. These components offer an array of product structures that can assist investors in developing and implementing investment strategies that respond to a changing financial world. OTC derivatives can assist the investor with cost minimization, diversification, hedging, asset allocation, and risk management.

Before we provide a product overview, let’s look at counterparty risk. For exchange listed derivative products counterparty or credit risk is minimal because of the clearing house associated with the exchange. However, for OTC products there is counterparty risk. For parties taking a position where performance of both parties is required, both parties are exposed to counterparty risk. The OTC market has incorporated a variety of terms into the contractual agreement between counterparties to address the issue of credit risk. These include netting arrangements, position limits, the use of collateral, recouponing, credit triggers, and the establishment ...