Tuesday, September 5, 2017

Over-the-counter market vs exchange-traded derivative contracts


One of the major advantages of exchange-traded futures and options is that the exchange guarantees every contract, thus relieving the holder of the risk of default by the writer. This means that potential option buyers are relieved of the burden of evaluating the creditworthiness of the writer. To protect itself against the risk of default by the writer for futures and options contracts, exchanges impose substantial capital and stringent margin requirements on option-writers. Membership requirements and standards are high and members’ positions are constantly monitored by the futures exchange. In addition, a futures exchange will maintain a large clearing fund to meet unforeseen circumstances.

 

Major international banks have for many years marketed the advantages and flexibility of futures and options contracts to their multinational corporate clients. Since multinational corporations have varied demands, not all of which can be matched by exchanges, banks have found it worthwhile to offer tailor-made futures and options contracts to meet the specific needs of their clients. This tailor-made market which allows for negotiation of the terms of the contract between the buyer and seller of an option is known as the over-the-counter market (OTC). The OTC market is dominated by major banks and securities houses, and contrasts with the standardized contracts on offer at the futures and options exchanges. The major advantage of the OTC market is that a client’s specific needs with regard to the size, exercise price and expiration date of the contract can be met.

 

Open interest is the outstanding number of contracts obligated for delivery. Consider four traders A, B, C and D, none of whom has any current position in a futures contract. If trader A takes a long position in a new contract with trader B taking a short position, then the open interest rises by one contract. Similarly, if trader C takes a long position in a futures contract with trader D taking the short position, then open interest rises by a further one contract.

 

 For most futures contracts, especially those that involve physical commodities such as gold, cotton and so on, the physical delivery of the commodity would be a cumbersome process. To avoid getting involved in the actual delivery process most traders enter into what is known as a reversing trade prior to the maturity of the contract. That is, they will liquidate their position at the clearing house so that they neither have to actually deliver or actually receive the underlying commodity. In our example, traders A and C are committed to buying the underlying commodity upon expiry, while traders B and D are committed to delivering it upon expiry. Trader A may not actually wish to receive the underlying commodity and trader D may not wish to actually deliver it, and hence at some date prior to expiry trader A and trader D will take out reversing trades to liquidate their positions. Trader A will take out a contract to sell the underlying commodity (at the then prevailing market price). As far as the clearing house is concerned, then A will have no net position in the futures market since it has an identical futures contract to both receive and deliver the underlying instrument. If trader A sold his contract to a new party E then the open interest would have been left unaffected by A’s trade. If, however, trader A had sold his position to trader D who was also undertaking a reversing trade, then open interest would have declined by one since both A and D have effectively negated their positions with the clearing house.

Jordan Schleider of NQ Trader and EJS
Jordan@nqtrader.us
jordan@ejs.net
http://ejs.net
http://nqtrader.us

 

 

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