There is now a rather large over-the-counter options market dominated by institutional investors. Chicago is no longer the center of the options market. The scope of this market is only the world now.
An option bought by a Japanese corporation from the New York office of an UK based bank, who in turn buys an offsetting option from the London office of an American Bank would not at all be unusual.
Parties to such contracts are large corporations, financial institutions even governments in which the option buyer is either familiar with the credit worthiness of the writer or has had the credit risk reduced by some type of collateral or other credit enhancement. There is always some element of credit risk still prevailing in such OTC transactions. But still people want to enter into such type of transactions as there are a lot of major advantages of this type of option.
The first and the major advantage is that these options are tailor made to suit the particular needs of the two parties. For example; the fund manager of a mutual fund wants to lock-in a particular selling price for his portfolio as he predicts that the market will be moving to his disadvantage, can buy a put option which will guarantee him that fixed selling price for his portfolio.
Unfortunately such a hedge may not be possible on an options exchange, mainly as options available on the exchange are based on certain stocks or stock indices.
The options available on options exchange may expire on particular dates which may not match the needs of the fund manager
In the over-the-counter markets, options can be created on a wider range of instruments than just stocks, like; bonds, commodities, currencies, and many other assets as well as some instruments that are not even assets, such as insurance damage and weather / rainfall / snowfall.
Another great advantage of the over-the-counter market is that other participants do not come to know that a particular transaction has occurred between any two parties. This does not mean that such transaction is illegal or suspicious. Just that secrecy is maintained and no signal – good or bad – is sent out to the market players, like in case of an exchange.
Clearly there are some disadvantages as well…
The main ones being, Credit risk exists and this market excludes the players who are not able to create enough creditworthiness.
The over-the-counter market is quite large but because of the private nature of the transactions, gauging its size is very difficult.
The Bank for International Settlements (BIS) conducts semiannual surveys that attempt to provide some data. These surveys, ho0wever, take a long time to complete and are published with a considerable lag. The BIS’s survey estimated that at year-end 1999, the notional principal, which is the amount of the underlying instrument, of options on interest rates, currencies, equities, and commodities was $13 trillion with a market value of about $ 490 billion.