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Contrast exchange-traded markets with OTC markets and outline what each is used for.

FRM® Part I · Financial Markets and Products · Exchanges and OTC Markets · FRM1.FM.5.f

The idea

Exchange-traded markets list standardised contracts with fixed sizes, maturities and strikes, trade them in one venue with published prices, and route them through a clearing house that collects margin. The result is liquidity, price transparency and little credit risk, which suits speculators, arbitrageurs, and hedgers whose exposure fits the contract terms. Over-the-counter markets are bilateral: two parties negotiate any amount, date and structure, so forwards, swaps and bespoke options can hedge an exposure exactly. The cost is counterparty credit risk, less transparency, and thinner liquidity in tailored deals. A hedger using a standard contract keeps rounding and basis risk, and a futures hedger also faces cash drains from daily settlement. Since the reforms, standardised OTC swaps are often centrally cleared, which blurs the line, although terms are still negotiated bilaterally. The choice is customisation against credit and liquidity features.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which transaction would normally be conducted over the counter?

  1. Buying a listed equity index option through an exchangeWhy not: Listed options have standard terms and are cleared; they are exchange-traded.
  2. Selling a Treasury bond futures contract through a clearing memberWhy not: Futures on exchange are standardised and cleared by definition.
  3. A tailored amortising interest rate swap agreed with a dealer - correct
  4. Entering a listed single-stock futures contractWhy not: Single-stock futures are listed contracts with fixed terms.

Customised swaps with specific notional schedules, dates and terms are negotiated bilaterally. Listed options and futures are standardised and exchange-traded.

A harder one

A treasurer must hedge a EUR 7.3 million receipt. Listed euro futures cover EUR 125,000 each and trade only in whole contracts. Which statement is correct?

  1. 59 contracts hedge the receipt exactly, leaving no residual.Why not: 59 contracts cover 7.375 million, over-hedging by 75,000.
  2. 58.4 contracts hedge the receipt exactly.Why not: Listed contracts trade in whole numbers, so a fractional hedge is not possible.
  3. 58 contracts leave EUR 400,000 unhedged.Why not: Reads the 0.4 contract fraction as 400,000 instead of 0.4 x 125,000.
  4. 58 contracts hedge EUR 7.25 million, leaving 50,000. - correct

7,300,000 / 125,000 = 58.4. With whole contracts, 58 cover 7,250,000, leaving 50,000. An OTC forward could match the exact amount and date.

The hardest tier

A producer hedges a future sale of 400,000 units by selling 400 futures contracts (1,000 units each) at 85.00. The futures price rises to 91.80. What is the main consequence for the producer?

  1. It receives USD 2.72 million of variation margin because the price rose.Why not: Gets the sign wrong: a short futures position loses when the price rises.
  2. It pays USD 2.72 million now, offset by a later physical gain. - correct
  3. It pays USD 2.72 million and has suffered a permanent loss because the hedge failed.Why not: Confuses interim cash flow with economic result; the physical position gains by a similar amount.
  4. It pays USD 2,720 of variation margin, which is immaterial.Why not: Forgets the 1,000-unit contract size and the 400 contracts when scaling.

Loss = 6.80 x 1,000 x 400 = 2,720,000, paid in cash through daily settlement. The hedge works economically because the physical sale gains, but only later, so the exchange hedge creates funding liquidity risk.

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