Contrast the exchange-traded and over-the-counter (OTC) segments of the derivatives world, including how each market is structured.
The idea
Exchange-traded derivatives are standardised contracts with fixed sizes, maturities and strikes. They trade on a regulated venue with transparent prices and are cleared by a clearing house that requires initial and daily variation margin. Over-the-counter derivatives are privately negotiated between two parties, usually with a dealer, so terms can be tailored to the hedge. Liquidity, price transparency and standardisation are lower. Historically OTC trades were bilateral, documented under an ISDA agreement and exposed each side to the other. Standardised OTC trades are now increasingly cleared centrally. The usual trade-off is customisation against counterparty risk and liquidity. A common mistake is to say exchange trading removes risk. It moves it to the clearing house and its margining system. Exam point: structure decides who your counterparty is.
Formulas
Variation margin on a futures position
VM = ΔF × multiplier × contracts
- ΔF
- the change in the futures settlement price, in index points
- multiplier
- the currency amount per index point
- contracts
- the number of contracts held
Settled daily: the long pays when the price falls and receives when it rises. Forgetting either the multiplier or the contract count is the usual slip.
A practice question
What best distinguishes exchange-traded derivatives from bilateral OTC contracts?
- Privately negotiated terms agreed between two parties and documented in a bilateral master agreementWhy not: Describes the OTC market, not exchange-traded contracts.
- Standardised contracts traded on a regulated venue and cleared with margin - correct
- Credit exposure that each counterparty bears directly to the other and manages through its own credit limitsWhy not: Describes bilateral OTC trading; on an exchange the clearing house becomes the counterparty.
- Contracts customised for each client's cash flows, with prices known only to the two partiesWhy not: Describes OTC customisation and opacity; exchange prices are public and terms standard.
Exchange-traded contracts have fixed terms, public prices and clearing-house margining. The OTC market is bilateral, customisable and less transparent.
A harder one
A corporate treasurer must hedge an amortising exposure whose schedule matches no listed contract. Which choice and trade-off best describes the situation?
- An OTC swap fits the cash flows, but adds counterparty risk and lower liquidity - correct
- Listed futures, because the exchange will tailor contract terms to each member's cash flowsWhy not: Wrongly believes exchanges customise; listed contracts have standard terms.
- An OTC swap, because OTC dealers are regulated and so counterparty risk is zeroWhy not: Overstates dealer safety; OTC trades carry real counterparty exposure to the dealer.
- Listed futures, because daily margining eliminates any mismatch between the hedge and the exposureWhy not: Margining reduces credit risk but does not remove basis risk from a poor cash-flow match.
OTC contracts can be tailored to the exposure, but each bilateral position carries credit exposure and the market is less liquid than listed contracts.
The hardest tier
Which statement best explains why counterparty exposure on exchange-traded derivatives is typically smaller than on uncollateralised OTC derivatives of the same size?
- Exchange-traded positions are always unleveraged, so the clearing house never has an exposure to membersWhy not: Wrongly says positions are unleveraged; futures are leveraged and the clearing house relies on margin.
- Daily variation margin resets mark-to-market, leaving only the move over the close-out period - correct
- OTC exposures are zero in practice because dealers net all trades with every client dailyWhy not: Overlooks that uncollateralised OTC exposure builds over the life of the trade and netting is only per counterparty.
- Exchanges remove all risk because the clearing house cannot be affected by the default of a memberWhy not: Wrongly treats a clearing house as risk-free; a member default can still cause losses beyond margin.
Daily variation margin keeps current exposure near zero on listed contracts; what remains is the potential move before a defaulting member's positions are closed. Uncollateralised OTC value can accumulate for years.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Derivatives
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