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Compare exchange traded derivatives and over the counter (OTC)
Let us learn about the exchange traded derivatives and over the counter (OTC) before understanding the differences between them.
Exchange traded derivatives
With a standardized contract, exchanged traded derivatives consist of options and futures mostly and traded on public exchanges. Determines expiry date, settlement process, lot size and states underlying instruments on which derivatives are created. By providing market based pricing information these derivatives promote transparency and liquidity.
Types
- Stock derivatives − Commonly traded asset class are common stock
- Index derivatives − Instead of simply future of a particular stock, these derivatives are sold to investors who like to buy/sell an entire exchange
- Currency derivatives − Currency pairs (future contracts or options) for trading.
- Commodities derivatives − Relates to raw materials.
- Real estate derivatives − Without owing physical buildings, invest in real estate.
Clearing and settlement
Clearing houses will handle both clear and settlement required tasks. Initial deposit required for a clearinghouse.
Advantages
- Highly liquid.
- Default risk reduces.
- Exchange platform is regulated.
Disadvantage
- Flexibility lost
Over the counter (OTC)
These securities are traded between parties without supervision of the exchange regulator. These are done through dealer networks in over the counter markets.
OTC securities cover a wide range of financial instruments (stock, derivatives, and debt securities) and commodities. Mostly covers stocks of smaller companies and sometimes cover stocks of larger companies.
Importance
Over the counter derivatives have exceptional significance and provide greater flexibility so that investors can adjust derivative contracts to suit their risk exposure. Trading OTC increases the liquidity in markets. Significant risk in OTC trading is counterparty risk. Fair value determination is based on contract design, more complicated the design and determination of fair value becomes harder.
Differences
The major differences between exchange traded derivatives and over the counter (OTC) are as follows −
| Sr.No | Exchanged traded derivatives | Over the counter (OTC) |
|---|---|---|
| 1 | Traded on exchange. | Traded on phones or through computers. |
| 2 | Contract is standardized. | Contract terms are agreed between the buyer and seller. |
| 3 | Information is public. | Information is private. |
| 4 | Termination is easy. | Difficult to terminate early. |
| 5 | Has a third party guarantor (clearing house). | No third party guarantor. |
| 6 | Require performance bond. | Performance bonds are not required. |
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