Short answer: An over-the-counter (OTC) derivative is a financial contract struck directly between two counterparties, meaning the two parties to the deal, instead of being traded on a formal exchange. Because these contracts are privately negotiated, their risk, return, size, expiry and settlement terms can be tailored to each party’s needs.
Last reviewed: 11 November 2026
At a glance
| Feature | OTC derivative |
|---|---|
| Where the contract is struck | Directly between two counterparties |
| Terms | Non-standardised, negotiated case by case |
| Central clearing | None; no clearing agency or central clearing and settlement system |
| Public disclosure of prices | Counterparties are not required to disclose publicly |
| Main categories | Interest rate, commodity, equity, currency and credit |
How is an OTC contract made?
A derivative is a contract whose value depends on something else, such as an interest rate, a commodity price, a share price, an exchange rate or a credit event. In an OTC deal, the two counterparties agree on every term themselves. They decide the size, the reference being tracked, the expiry date and how payments will be settled.
Nothing in the contract forces it onto a common template. This is the key difference from a standardised contract, where the terms are fixed in advance by the exchange and every buyer and seller trades the same product.
What makes OTC different from exchange-traded contracts?
Exchange-traded futures carry standardised terms, so a buyer and a seller can trade the same contract at any time through the exchange. OTC contracts are non-standardised, which gives flexibility but also makes them harder to swap with someone else later. A contract negotiated for one company’s exact needs may have few ready buyers if that company wants to exit early.
What are the main types?
OTC derivatives fall into five main categories. Interest rate derivatives depend on interest rates, commodity derivatives on the price of goods, equity derivatives on shares or share indices, and currency derivatives on exchange rates. Credit derivatives depend on the credit risk of a borrower.
A credit default swap is a common type of credit derivative. It shifts credit risk from one party to another without the exchange of the underlying assets, so the party buying protection does not need to sell the loan or bond it is worried about.
How is it used for hedging?
Hedging means taking an offsetting position so that adverse price moves in an existing exposure are reduced. A business that already faces a price risk can use an OTC contract to take the opposite side of that risk.
Here is a hypothetical example, with invented figures for illustration only. Suppose two parties sign an OTC contract on a notional amount of ₹10,00,000 (ten lakh rupees), which is the amount used only to calculate payments. The contract pays the difference if a reference price falls from 100 to 90, a 10% fall. The payment is 10% of ₹10,00,000, which is ₹1,00,000. If the reference price had stayed at 100, no payment would have been due under this invented contract.
What is the biggest risk?
Because there is no clearing agency or central clearing and settlement system, each party is exposed to the other side defaulting. If the counterparty cannot pay what the contract requires, the other party has no central body standing between them to guarantee the payment.
In the hypothetical example above, the party due to receive ₹1,00,000 is relying entirely on the other side paying. The hedge protects against the price move only if the counterparty honours the contract. This is the main catch of OTC derivatives, and it grows with the size of the contract.
How transparent are OTC prices?
OTC counterparties are not required to publicly disclose the prices at which they trade. This differs from trades on a regulated exchange, where prices are visible to the market. A party to an OTC deal may therefore find it harder to check whether the price it agreed is in line with what others are paying for a similar contract.
Where does the flexibility come at a cost?
Tailored terms can fit a specific need well, but they bring three costs. First, the contract may be hard to exit or transfer. Second, the exposure to the other party’s default stays in place for the life of the deal. Third, the prices are not publicly disclosed, so comparisons are harder to make.
Understanding these trade-offs is the best starting point for anyone reading about OTC derivatives.
Frequently asked questions
Is an OTC derivative the same as an exchange-traded future?
No. An OTC derivative is struck directly between two counterparties and its terms are negotiated case by case. An exchange-traded future carries standardised terms and is traded on a formal exchange.
Who guarantees payment if the other side of an OTC deal defaults?
No clearing agency or central clearing and settlement system exists for OTC derivatives. Each party is therefore exposed to the other side defaulting.
What are the main categories of OTC derivatives?
The main categories are interest rate, commodity, equity, currency and credit derivatives. Credit default swaps are one type of credit derivative.
Can the prices of OTC trades be seen publicly?
Not necessarily. OTC counterparties are not required to publicly disclose the prices at which they trade, unlike trades on a regulated exchange.
Sources and last check
Facts in this article were checked against the sources below on 11 November 2026. Rules and figures can change; check the primary source before acting.
- kotakneo.com (broker education)
- icicidirect.com (broker education)
- upstox.com (broker education)
This article is general information, not investment advice. MyFinanceBandhu is not a SEBI-registered investment adviser.