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Over-the-Counter Derivatives Markets
To manage the risk they assume by buying and selling customized derivatives, OTC derivatives dealers typically hedge their risks by engaging in alternative but similar transactions that pass the risk on to other parties. For example, if a company comes to a dealer to buy a derivative on the euro, the company would effectively be transferring the risk of the euro to the dealer. The dealer would then attempt to lay off (get rid of) that risk by engaging in an alternative but similar transaction that would transfer the risk to another party. This hedge might involve another derivative on the euro or it might simply be a transaction in the euro itself. Of course, that begs the question of why the company could not have laid off the risk itself and avoided the dealer. Indeed, some can and do, but laying off risk is not simple. Unable to find identical offsetting transactions, dealers usually have to find similar transactions with which they can lay off the risk. Hedging one derivative with a different kind of derivative on the same underlying is a similar but not identical transaction. It takes specialized knowledge and complex models to be able to do such transactions effectively, and dealers are more capable of doing so than are ordinary companies. Thus, one might think of a dealer as a middleman, a sort of financial wholesaler using its specialized knowledge and resources to facilitate the transfer of risk. In the same manner that one could theoretically purchase a consumer product from a manufacturer, a network of specialized middlemen and retailers is often a more effective method.
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