OTC Derivative Markets Overview

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Questions and Answers

What main problem does illiquidity create for forward contracts?

Difficulty exiting before maturity (correct)

Ability to modify contract terms easily

Increased profitability for both parties

Higher transaction costs on exchanges

What is counterparty risk primarily concerned with?

The risk of market price fluctuations

The risk of counterparty failing to fulfill obligations (correct)

The risk of interest rate changes

The risk of government regulation changes

How are futures contracts different from forward contracts?

Futures are less liquid than forwards

Futures are not standardized

Futures are backed by a clearing corporation (correct)

Futures require no pricing agreement

Which of the following is a key feature of futures contracts?

The exchange decides all terms except the price Signup and view all the answers

What could incentivize a party to default on a forward contract?

Price of the underlying asset decreases Signup and view all the answers

What does a trader in a long position of a futures contract expect?

Price will increase Signup and view all the answers

Which of the following issues does not typically affect futures contracts?

Centralization of trading Signup and view all the answers

What role does the clearing corporation play in the futures market?

Guarantees settlement of trades Signup and view all the answers

What is a primary characteristic of OTC derivative markets compared to exchange-traded derivatives?

Contracts are tailor-made for specific requirements. Signup and view all the answers

Which type of market participant is NOT typically associated with OTC derivative markets?

Retail investors Signup and view all the answers

What does the lack of formal rules in OTC derivative markets imply?

Increased credit risk management on an individual level. Signup and view all the answers

How does the derivatives market improve price discovery?

Based on actual valuations and expectations of the market. Signup and view all the answers

What is one significant function of derivatives in the financial market?

To enable high risk appetite participants to take on others' risks. Signup and view all the answers

What is a potential disadvantage of OTC derivative markets?

Higher counter-party risk due to a lack of formal oversight. Signup and view all the answers

What is the primary purpose of cash and carry arbitrage?

To align prices between cash and futures markets. Signup and view all the answers

In OTC markets, how are risks typically managed?

On an individual institutional basis. Signup and view all the answers

What happens when the futures price is less than the fair futures price?

It leads to reverse cash and carry arbitrage. Signup and view all the answers

What is a unique feature of exchange-traded derivatives compared to OTC derivatives?

Prices are determined through public bidding processes. Signup and view all the answers

Which of the following is NOT a component that distorts the no-arbitrage bounds?

Foreign exchange rates Signup and view all the answers

What results from trading activity attempting to exploit an arbitrage opportunity?

Alignment of prices between cash and futures markets. Signup and view all the answers

What would most likely happen if transaction costs were lower in the futures market?

The no-arbitrage bounds would tighten. Signup and view all the answers

How does holding gold and delivering it in the futures market affect the total profit?

It generates a profit without risk when executed properly. Signup and view all the answers

What is the result of a wider no-arbitrage bound?

Markets are farther from equilibrium. Signup and view all the answers

What must occur for arbitrage to be triggered?

Futures price must exceed or fall below no-arbitrage bounds. Signup and view all the answers

What is one of the essential attributes of a good market index?

It should reflect the market behaviour. Signup and view all the answers

What does liquidity in the stock market refer to?

A market where large orders can be executed without affecting prices. Signup and view all the answers

What is the bid-ask spread in the order book example provided?

0.50 Signup and view all the answers

What transaction cost does a person incur when buying 100 shares and immediately selling them based on the order book?

Rs. 50 Signup and view all the answers

What happens to the transaction cost when increasing order size from 100 shares to 3000 shares?

It increases. Signup and view all the answers

Which of the following best describes an ‘impact cost’ in trading?

The cost incurred due to the effect of a large trade on market prices. Signup and view all the answers

What does a professional maintenance of a market index imply?

It accurately reflects market dynamics without bias. Signup and view all the answers

Why is it important for a market index to be computed by an independent third party?

To avoid conflict of interest and maintain objectivity. Signup and view all the answers

What term describes a market condition where futures prices are higher than the spot prices, indicating expectations of rising prices?

Contango market Signup and view all the answers

What can be inferred when the futures prices are lower than the spot prices?

The market expects the spot price to fall Signup and view all the answers

What is the key principle regarding futures prices as they approach maturity?

They will converge to the spot price of the underlying asset Signup and view all the answers

In the context of futures pricing, what does the term 'price discovery' refer to?

The process of predicting future spot prices by market participants Signup and view all the answers

Which type of market participant primarily seeks to minimize risk associated with price fluctuations in the underlying asset?

Hedgers Signup and view all the answers

During the expiry of a futures contract, what happens to the futures price?

It settles at the underlying cash market price Signup and view all the answers

What do participants in a 'Backwardation market' expect regarding future spot prices?

They expect spot prices to fall Signup and view all the answers

Which of the following roles in the derivatives market is primarily focused on taking advantage of price differences?

Arbitrageurs Signup and view all the answers

Study Notes

OTC Derivatives Market

Contracts are matched through a negotiated bidding process via telephone or electronic media links between intermediaries.
The market has seen significant growth due to advancements in information technology.
Participants include banks, financial institutions, hedge funds, corporations, and high net-worth individuals.
It operates as a less regulated market, with transactions occurring privately between qualified counterparties.

Features of OTC Derivatives

Contracts are customized to meet specific requirements of dealing parties.
Counterparty credit risk management is decentralized within individual institutions.
No formal central limits exist on positions, leverage, or margining.
Lack of centralized risk management rules can affect market stability and integrity.
Transactions occur privately with minimal market disclosure.

Exchange-Traded Derivatives vs OTC Derivatives

Exchange-traded contracts are standardized and traded on organized exchanges.
Prices are determined through anonymous auction interfaces.
Clearing corporations guarantee the performance and settlement of exchange-traded transactions.

Significance of Derivatives

Enhances price discovery based on real valuations and future expectations.
Facilitates risk transfer from low-risk appetite holders to those willing to assume risk (e.g., hedgers to traders).
Encourages speculative trades to move from unregulated to organized markets, improving overall market stability.

Attributes of a Good Market Index

Should accurately reflect market behavior.
Must be calculated by an independent third party, preventing market participant influence.
Requires professional maintenance for integrity.

Liquidity in Stock Markets

Defined as the ability to execute large orders without affecting prices.
Bid-ask spread represents the transaction cost; a market buy order can incur losses due to this spread.
Larger order sizes (e.g., 3000 shares) lead to increased transaction costs due to greater market impact.

Counterparty Risk

The risk of financial loss if a counterparty fails to fulfill contractual obligations (also known as default risk or credit risk).
Incentives for default may arise if market prices deviate favorably compared to contract terms.
Illiquidity and transparency issues compounded by direct settlement complications.

Futures Contracts

Designed to overcome limitations of forward contracts, offering a standardized agreement to buy/sell assets at a future date through organized exchanges.
Clearing corporations associated with exchanges ensure trade settlement.
Traders take long positions by buying futures and short positions by selling.

Cost of Transaction and No-Arbitrage Bounds

Costs like margins and transaction fees create barriers, maintaining futures prices within no-arbitrage bounds.
Futures prices reflect expected future spot prices, influencing market behavior and arbitrage opportunities based on deviations from these bounds.

Market Conditions: Contango and Backwardation

Contango occurs when futures prices are higher than spot prices, indicating expectations of price increases.
Backwardation occurs when futures prices are lower than spot prices, suggesting expectations of price decreases.

Price Discovery and Futures Expiry

Futures prices indicate market expectations for asset valuation at contract maturity.
Prices converge at contract expiry, ensuring no price differences between futures and spot markets.

Roles of Market Participants

Participants are categorized as hedgers, who manage risk; speculators, who seek profit from price movements; and arbitrageurs, taking advantage of price discrepancies across markets.

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Description

Explore the dynamics of over-the-counter (OTC) derivative markets, focusing on the growth driven by technology and the role of various market participants. This quiz highlights the process of contract buying and selling through negotiated bidding and the impact of intermediaries in the network.