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Subject 2. Derivative Markets PDF Download

Based on the markets where they are created and traded, derivatives can be classified into two groups.

Exchange-Traded Derivatives Markets

Exchange-traded derivatives are created, authorized, and traded on a derivatives exchange, an organized facility for trading derivatives.

  • They are standardized instruments with respect to certain terms and conditions of contracts. This specification applies to features like the schedule of expiry dates and contract magnitude. The market participants in the exchange-traded derivatives markets are the market-makers (dealers) and speculators who are typically exchange members. The interplay between market makers and speculators creates a more liquid and more orderly market.

  • The standardization also ensures clearing (verification of transaction and identities) and settlement (transfer of money) of derivatives contracts happens efficiently and allows for the provision of a credit guarantee by the clearinghouse. The clearinghouse can provide this guarantee through the requirement of a cash deposit called a margin bond or performance bond.

  • Exchange-traded markets have transparency as full information on the transactions is disclosed to the exchange and regulatory bodies. This does mean a loss of privacy and, coupled with the standardization, a loss of flexibility. As an alternative to standardization, OTC markets provide a substitute for firms wishing to trade non-standardized products.

Over-the-Counter Derivatives Markets

Over-the-counter derivatives are transactions created by any two parties off a derivatives exchange.

  • They don't have standardized terms and features. The parties set all of their own terms and conditions, and each party assumes the credit risk of the other party. It can be difficult for a dealer to find a contract that is a perfect match to hedge a position, and they usually have to rely on similar transactions in which they can lay off their risk. The ability to customize OTC contracts does not necessarily make the market less liquid than the standardized exchange-traded contracts. As many of the OTC instruments can be easily created, an offsetting instrument can be created, oftentimes between the same two transacting parties, to terminate the position.

  • OTC markets do have a lower level of regulation than exchange-traded markets. However, post the 2007 financial crisis, regulatory oversight has been increasing. On full implementation of new rules, many OTC transactions will have to be cleared through central clearing agencies with information reported to the regulatory authorities.

User Contributed Comments 8

User Comment
epizi Exchange traded derivatives are standardised while OTC are customised to the taste of the parties involved.

Exchange traded risk of default is guaranteed by exchange whereas OTC parties gaurantee risk
BunnyBaby Exchange traded derivatives seem safer because you have the guarantee of the government regulations to appeal to, as well as the back of the exchange for the specific security. What effect does this difference in risk have on the liquidity and price of the securities?
kutta2102 One would think that liquidity is less since there are fewer parties who would be interested in buying/selling contracts where terms are very specific and not standardized. Therefore, if one can find an identical (or similar) instrument trading on an exchange, the difference would be in the bid-ask spread.
kutta2102 To add to my previous comment - the whole credit crisis of 2008 sort of imploded because of the counterparty risk. The repo market for Bear Stearns and Lehman froze once other companies found out that the collateral they were using had all these toxic assets.
akotova1 Exchange traded would be more liquid and prices less volatile
johntan1979 Oh no, akotova1... I can assure you that the OTC is much much much much much more liquid
johntan1979 Whoops, sorry about that comment. Just realized my mistake after reading the next section.
To-be-CFA Classification on basis of Markets:
I. Exchange-traded
- Standardized instruments.
- Subject to government regulations.
- Guaranteed by the exchange against default risk.

II. Over-the-counter
- No standardized T&C.
- Each party assumes the credit risk of the other party.
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