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OTC Derivatives

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.


Interest An interest rate swap involves the exchange of cash flows between two parties based on interest payments for a particular principal amount. However, in an interest rate swap, the principal amount is not actually exchanged. In an interest rate swap, the principal amount is the same for both sides of the currency and a fixed payment is frequently exchanged for a floating payment that is linked to an interest rate, which is usually LIBOR.

Currency: A currency swap involves the exchange of both the principal and the interest rate in one currency for the same in another currency. The exchange of principal is done at market rates and is usually the same for both the inception and maturity of the contract.

Mark to market (MTM)

Mark to market (MTM) is a measure of the fair value of accounts that can change over time, such as assets and liabilities. Mark to market aims to provide a realistic appraisal of an institution's or company's current financial situation.


Balance Sheet Hedging : This method consists of three primary actions: Measuring the impact of exchange rate volatility on the value of monetary assets and liabilities denominated in non-functional currencies; Forecasting these assets and liabilities in advance to plan appropriate hedging strategies; Ensuring that the liquidity provision, either in local or in functional currency does not exert a negative impact on the balance sheet.

One of the most common methods to hedge balance sheet items, such as foreign currency denominated payables and receivables or cash holdings is to purchase a financial instrument, such as a forward, future or options contract for the same amount and maturity. Hedging balance sheet items involve complying with accounting standards, which compel the company to recognise the changes in the value of the hedge contract as well as the changes in the underlying asset on the balance sheet. The value of both the hedged asset and the hedging instrument have to be translated into the functional currency using the current spot exchange rate at every reporting period. If the hedging instrument is appropriate to cover the exposure of the underlying assets, the variations in the value of the one get offset with opposite variations in the value of the other. Thus the resulting FX gains and losses are minimal.

Currency: A cash flow hedge is a hedge of the exposure to variability in the cash flows of a specific asset or liability, or of a forecasted transaction, that is attributable to a particular risk. It is possible to only hedge the risks associated with a portion of an asset, liability, or forecasted transaction, as long as the effectiveness of the related hedge can be measured. The accounting for a cash flow hedge is as follows: Hedging item. Recognize the effective portion of any gain or loss in other comprehensive income, and recognize the ineffective portion of any gain or loss in earnings. Hedged item. Initially recognize the effective portion of any gain or loss in other comprehensive income. Reclassify these gains or losses into earnings when the forecasted transaction affects earnings. A key issue with cash flow hedges is when to recognize gains or losses in earnings when the hedging transaction relates to a forecasted transaction. These gains or losses should be reclassified from other comprehensive income to earnings when the hedged transaction affects earnings.

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Disclosure : Neither FX fundamental nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets. Investment products, insurance and annuity products.