27 Understanding Derivatives—Markets and Infrastructure Federal Reserve Bank of Chicago, © 2014 Over-the-Counter (OTC) Derivatives

The demand for customized derivatives contracts, efficient trading of large contracts, and liquidity are the main drivers of OTC deriva-tives markets. The primary reason to use an OTC contract, as opposed to an exchange-traded contract, is to create a “perfect ” hedge, both for hedge accounting purposes (see Box 1) and to satisfy other require-ments, such as a need for the physical delivery of a commodity at a location or date that may not exist at an exchange. Customized con-tract terms can minimize so-called basis risk, facilitating “perfect” hedging. Basis risk arises when exposure to the underlying asset, liability, or commodity that is being hedged and the hedge contract (the derivatives contract) are imperfect substitutes. Imperfections Understanding Derivatives: Markets and Infrastructure Over-the-counter1 (OTC) derivatives are bespoke contract