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What are over-the-counter derivatives?

Over-the-counter (OTC) derivatives are financial instruments that are traded directly between two parties, rather than on a regulated exchange. OTC derivatives are commonly used to hedge risk or to speculate on the future movements of an underlying asset, such as a currency, interest rate or commodity. One type of OTC derivative is a contract for difference (CFD), which allows traders to speculate on the price movements of an underlying asset without actually owning the asset.

Unlike exchange-traded derivatives, which are standardised and traded on a regulated exchange, OTC derivatives are customised to meet the specific needs of the parties involved. This means that the terms and conditions of the contract are negotiated between the two parties, rather than being predetermined by the exchange.

One of the main advantages of OTC derivatives is that they provide flexibility and customisation for parties looking to hedge risk or speculate on the future movements of an underlying asset. This can be especially useful for businesses that need to manage their exposure to certain risks, such as changes in interest rates or currency fluctuations.

However, OTC derivatives also have some drawbacks. Because they are traded directly between two parties, they are not subject to the same level of regulation as exchange-traded derivatives. This can make them more risky, as there is no central clearinghouse to guarantee the performance of the contract. Additionally, because the terms and conditions are negotiated directly between the parties involved, there is a greater potential for disputes and disagreements.

Overall, OTC derivatives, including CFDs, can be a useful tool for managing risk or speculating on the future movements of an underlying asset. However, they come with additional risks and should be carefully considered before entering into a contract.

“Be radically open-minded and radically transparent.” – Ray Dalio

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