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Over the Counter

Public stock issues that are not traded in any domestic stock exchange are traded in the OTC market. The OTC market is a negotiated market, whereas most stock exchanges are auction markets. The shares of publicly traded companies that are not listed on a stock exchange may be traded on an OTC market.

An over-the-counter stock market is a network of brokers and dealers that trade stocks and bonds that are not listed on an Exchange. Sometimes companies prefer to be listed on an OTC market instead of listing on a stock exchange. Over-the-Counter market is a stock exchange where securities transactions are made via internet and telephone than on the floor of an exchange.

In Over-the-Counter (OTC) markets, an investor who wants to sell an asset must search for a buyer, incurring opportunity or other costs. When two counterparties meet, their bilateral relationship is strategic. Prices are set through a bargaining process that reflects each investor’s alternatives to immediate trade. The buyer, in particular, considers the costs that he or she will eventually incur when he or she wants to sell, and so on for all future owners. We build a dynamic asset-pricing model that captures these features. Under natural conditions, prices are higher if investors can find each other more easily, if sellers have more bargaining power, or if the fraction of qualified owners is greater. If agents face risk limits, then higher volatility leads to greater difficulty locating unconstrained buyers, resulting in lower prices. Information can fail to be revealed through trading when search is difficult.

The OTC market has a big role to play in the primary market. Many new stock issues are sold over-the-counter initially. Large block of outstanding shares offered for a sale by a single investor, whether listed on an exchange or not, are sometimes sold in the OTC stock market. The disclosure standards for the OTC market are not as stringent as those imposed by a stock exchange. Corporations whose shares are listed on an exchange are generally not allowed to list or trade on the OTC market and vice versa.

Even in the most liquid OTC markets, the relatively small price effects arising from search frictions receive significant attention by economists. An over-the-counter market considered to be a benchmark for high liquidity, is subject to widely noted illiquidity effects that differentiate the yields of on-the-run (latest-issue) securities from those of off-the-run securities. Positions in on-the-run securities are normally available in large amounts from relatively easily found traders such as hedge funds and government-bond dealers.

Financial decision makers often consider the forward-looking information in currency option valuations when making assessments about future developments in foreign exchange rates. The OTC quotes include volatilities, strangles and risk-reversals on the dollar, yen and pound per euro as well as on yen per dollar. In addition to volatility forecasts we evaluate option based interval and density forecasts which are widely used by practitioners but which have not been systematically assessed so far. OTC options are quoted daily with fixed money in contrast with market-traded options which have fixed strike prices and thus time varying money as the spot price changes. Finally, the trading volume in OTC options is often much larger than in the corresponding market traded contracts which in turn is likely to render the OTC quotes more reliable for information extraction.

The market for OTC derivatives has expanded steadily and rapidly over the past two decades. According to Bank for International Settlements (BIS), the vast majority of OTC derivatives are interest rate and foreign exchange contracts; equity-related contracts make up only 2 percent of the market, while tangible commodities account for a fraction of a percent.

Activity in OTC derivatives markets has been primarily concentrated in three types of instruments: swap agreements, options and hybrid instruments. The typical swap agreement is a contract between two parties providing for the exchange of cash flows based on differences or changes in the value or level of one or more interest rates, currencies, commodities, securities, or other asset categories. These cash flows are calculated with reference to a principal base (known as the “notional amount”) of the underlying asset category. Because the notional amount of a swap agreement is only a contractual term used to calculate the amount of payments under the swap agreement, it generally is not exchanged between the parties to the agreement. Accordingly, the notional amount is not a measure of the value or the risk in a swap agreement.

As OTC markets develop, however, the extent to which market participants engage in large numbers of transactions with similar terms increases, because certain instruments serve the risk-management needs of a large number of market participants. Thus, the opportunity to negotiate the terms and conditions of an instrument may exist, but in practice this opportunity may not be used to a great extent for certain types of instruments. Moreover the widespread use of innovations such as electronic online trading and clearing have the potential to increase efficiency and reduce systemic risk, they could also blur some of the distinctions between exchange-traded and OTC instruments.

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