An over the counter market (OTC) is a decentralized market for securities where market players trade over the telephone and other electronic systems instead of the physical trading on the floor (Poitras 50). …
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Securities traded in this market are not listed on the organized stock exchanges such as the Nasdaq Stock market. Some securities that are traded in the over the counter markets include common stocks, bonds, and derivatives such as forward contracts and interest rate swaps. OTC market is conducted through brokers and dealers thus is a negotiated market where trading is carried out through computer systems and telephone conversations (Poitras 61). The securities traded on OTC market are usually small since the issuers have not met the listing requirements. Though Nasdaq trades through a network of dealers, it is not an OTC market but an organized stock exchange market where trading is carried out on the floor (Poitras 73).
Each year, billions of dollars are exchanged in the OTC market. OTC market mainly consists of derivative financial assets such as the forward contracts, interest rate swaps and options. The derivative market has experienced a phenomenal growth since 2000. Derivative instruments were designed for the agricultural industry to hedge the farmers against crop failure, or expected price movements. Derivative contracts have been extended to the main sectors of the economy including oil industry, gold markets and financial sector. Derivatives have the potential of hedging against unforeseen risks and price moments but are subject to abuse by greedy investors (Wood 67).
The Commodity Future Trading commission has the mandate of regulating the derivatives market including derivatives traded in the stock exchanges. The derivatives traded in the exchange markets account for $ 334 trillion each year meaning the value of the underlying assets involved is also $ 334 trillion. The main derivatives in the exchange markets are options and future contracts. However, most of the derivative instruments do not trade on the exchange markets, but are transacted in the OTC market. Each year, $ 684 trillion of underlying assets are traded in the OTC market where most of the derivative assets traded include the interest rate swaps, currency swaps, credit default swaps, commodity indexes and exchange rate swaps (Madura 90). Derivative contracts have one similar feature since their value depends on the price movements of the underlying asset (Wood 87). The underlying asset may be a physical commodity or a stock market index or the rate of interest prevailing in the market. Derivative instruments such as options, swaps and future or forward contracts lose or gain value as the underlying asset changes in value even though the holder of the derivative may not be the owner of the underlying asset (Madura 117). Millions of business firms use the derivative instruments to manage foreign exchange risks. Firms protect their profitability against the raw material price increase by entering in to a derivative contract that automatically increases in value when price of the raw material increase. For instance, Southwest Airlines managed to purchase jet fuel at lower prices in 2008 when the energy prices were soaring since it had entered in to a derivative position (Madura 198). Generally, there are two categories of derivative contracts. The first is the option contract that providers the option holder the choice of buying or selling the underlying asset over a certain period of time. The other is the future contract, this contract obligates the holder to buy or sell the underlying asset on the expiry of the contract period. All other derivatives such as options and swaps have evolved from the above two derivative contrac
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