What it means
Exchange-traded options come in standard sizes, strike prices and expiry dates. An OTC option can be built to measure: any underlying asset, any amount, any strike price and any expiry date that the two sides agree.
That makes OTC options especially useful for companies hedging particular exposures that do not match a standard contract. The buyer pays a premium up front for the right the option provides.
The seller, who receives the premium, takes on the obligation to deliver if the buyer chooses to exercise. The premium reflects how likely the option is to be valuable, which depends on the current price, the strike price, the time left and expected volatility.
Pricing is agreed with the dealer, and there is no public order book to show a competitive price. A treasurer therefore asks several banks for quotes and checks them against a pricing model.
The bank's quote includes a margin for its own profit and the risk of hedging the position. Counterparty risk is a central issue.
If the option ends up valuable to the buyer, the buyer depends on the seller to pay up. To manage that, the two parties often sign a master agreement, which sets common terms for all their derivatives, along with arrangements for posting collateral, meaning assets pledged as security.
Accounting also needs care. Depending on how the option is used, it may be recorded at fair value with changes going through profit or loss, or it may qualify for hedge accounting, which matches its gains and losses to those of the item being hedged.
The finance team should agree the treatment before trading, not afterwards.
In practice
Real-world examples.
Example
An airline buys a tailored option giving it the right to buy a set quantity of fuel at a fixed price over the next nine months. The contract matches its expected purchases exactly, which a standard exchange contract could not do. If fuel prices fall, it simply lets the option lapse and buys at the lower market price.
Example
A technology founder holds shares worth $5,000,000 following a listing and wants to protect against a fall without selling. She buys an OTC put option from a bank with an expiry that matches the end of her lock-up period. The premium is the cost of insurance against a price drop.
Example
An exporter expecting a payment in 12 months buys a currency option that sets a minimum exchange rate. If the currency strengthens, it benefits from the better rate, and if it weakens, the option protects the minimum.
Formula
Calculation
Net profit on a call option = (market price at expiry - strike price) x quantity - premium paid
A fund buys an OTC call option on 10,000 shares with a strike price of $50 and pays a premium of $3 per share, so the premium paid is 3 x 10,000 = $30,000. At expiry, the market price is $58. The option is worth (58 - 50) x 10,000 = $80,000, so the net profit is 80,000 - 30,000 = $50,000. If the market price had been $50 or below, the option would expire worthless and the loss would be limited to the $30,000 premium.Case study
Seen in the real world.
Silverton Foods is a fictional food manufacturer, and this story is illustrative. It buys wheat throughout the year and wanted to cap its costs without giving up the benefit of falling prices.
The treasurer bought an OTC call option from a bank on 5,000 tonnes of wheat at a strike price of $300 per tonne for a premium of $12 per tonne, a total of $60,000. When prices rose to $340, the company exercised the option and saved (340 - 300) x 5,000 = $200,000, a net gain of $140,000 after the premium.
In a later year, prices fell and the option expired unused, costing only the $60,000 premium. The illustrative lesson is that an option works like insurance, and a premium that seems wasted in a good year is the price of protection in a bad one.
Watch out
Common mistakes.
- Forgetting to include the premium when calculating profit, which overstates the gain from the option.
- Ignoring counterparty risk, when an OTC option is only as good as the seller's ability to pay.
- Choosing a customised option when a standard contract would do, which usually costs more because of the dealer's margin.
Questions
People also ask.
Can an OTC option be sold before it expires?
Sometimes, but usually only back to the original dealer or by agreement, because there is no public market.
What is the maximum loss for the buyer of an option?
The premium paid, because the buyer has a right and not an obligation.
How are OTC options different from exchange-traded options?
They are customisable and privately negotiated, while exchange-traded options are standardised and guaranteed by a clearing house.
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