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10.2.2 Derivative Markets

Learn key concepts about derivative markets including their structure, types, features, and differences between the over-the-counter (OTC) market and exchange-traded derivatives.

Overview

As discussed in previous chapters, most bonds trade in the over-the-counter (OTC) market, while stocks and derivatives trade on both the OTC market and organized exchanges. The primary difference between exchange-traded and OTC stocks and bonds lies in trading mechanics. However, the differences between exchange-traded and OTC derivatives are even more pronounced.

Over-The-Counter (OTC) Derivatives

The OTC derivatives market is an active and vibrant market consisting of a loosely connected and lightly regulated network of dealers who negotiate transactions directly with one another. Negotiations typically occur via telephone or through computer terminals.

Key Characteristics

  • Dominated by Financial Institutions: Banks and investment dealers primarily dominate this market, trading with large corporate clients and other financial entities.
  • No Central Trading Floor: There is no physical trading floor, and no regular trading hours. Trading can occur at any time, with some staff working nights, weekends, and holidays.
  • Custom Contracts: OTC derivatives are attractive because contracts can be custom-designed to meet specific needs, leading to more complex instruments than those traded on exchanges.

Exchange-Traded Derivatives

A derivative exchange is a legal corporate entity organized for the trading of derivative contracts. It provides facilities either through a physical trading floor, an electronic system, or both. The exchange also enforces rules and regulations to maintain market fairness, order, and transparency.

Key Functions

  • Addresses OTC Issues: Designed to address problems such as lack of standardization, liquidity concerns, and default risk associated with OTC markets.
  • Standardization: Exchange-traded derivatives are standardized contracts, which makes them less flexible but easier to trade and understand.

Example: Montréal Exchange

Canada has one derivative exchange: The Montréal Exchange (or Bourse de Montréal), which lists options on stocks, indexes, and U.S. currency, as well as exchange-traded forwards (futures) on bonds, bankers’ acceptances, and indexes.

Key Takeaways

  • OTC Market: More flexible but less regulated, targeted towards institutional investors requiring customized derivatives.
  • Exchange-Traded: More standardized and regulated, aimed at addressing issues like liquidity and default risk.
  • No Centralization vs. Organized Structure: OTC lacks a central trading venue, whereas exchanges like the Montréal Exchange offer organized trading facilities.

FAQs

Q1: What is the primary difference between OTC and exchange-traded derivatives?

A1: The primary difference is that OTC derivatives are negotiated directly between parties, making them less standardized and more flexible. Exchange-traded derivatives are standardized contracts traded on regulated exchanges.

Q2: Why are OTC derivatives appealing to corporate clients?

A2: OTC derivatives are appealing because they can be custom-designed to meet the specific needs of corporate clients.

Q3: What role does the Montréal Exchange play in Canada’s derivative market?

A3: The Montréal Exchange is Canada’s sole derivative exchange, listing various options and futures on financial instruments.

Glossary

  • Derivative: A financial instrument whose value is derived from the value of an underlying asset, such as stocks, bonds, or currencies.
  • OTC Market: Over-the-counter market where trades are negotiated directly between parties.
  • Exchange-Traded: Trading of standardized contracts on a regulated exchange.
  • Montréal Exchange: Canada’s only derivative exchange, listing options and futures on various assets.
    graph TD;
	    A[OTC Market] -->|Flexible Contracts| B[Corporate Clients];
	    A -->|Direct Negotiations| C[Banks & Institutions];
	    D[Exchange-Traded Derivatives] -->|Standardized Contracts| E[Investors];
	    D -->|Regulated Market| F[Transparency & Fairness];
	    D --> G[Montréal Exchange];

📚✨ CSC Exam Bank ✨📚

Welcome to the Knowledge Checkpoint! You'll find 10 carefully curated CSC exam practice questions designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you're on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

Good luck!

## Where do stocks and derivatives primarily trade? - [ ] Only on organized exchanges - [ ] Only in the OTC market - [x] Both in the OTC market and organized exchanges - [ ] Neither in the OTC market nor organized exchanges > **Explanation:** Stocks and derivatives trade both in the OTC market and organized exchanges, while bonds primarily trade in the OTC market. ## What is one key feature of OTC derivatives that attracts corporations and institutional investors? - [ ] Standardization - [x] Customization - [ ] Limited negotiation - [ ] Restricted trading hours > **Explanation:** OTC derivatives can be custom-designed to meet specific needs, making them attractive to corporations and institutional investors. ## Who primarily negotiates transactions in the OTC derivatives market? - [ ] Retail investors - [ ] Government agencies - [x] Financial institutions and large corporate clients - [ ] Small-cap companies > **Explanation:** The OTC derivatives market is dominated by financial institutions, such as banks and investment dealers, that trade with their large corporate clients and other financial institutions. ## Which of the following is a characteristic of the OTC derivatives market? - [ ] Centralized trading floor - [ ] Regular trading hours - [x] Lightly regulated network of dealers - [ ] High standardization > **Explanation:** The OTC derivatives market consists of a loosely connected and lightly regulated network of dealers who negotiate transactions directly. ## What type of entity is a derivative exchange? - [ ] A government organization - [x] A legal corporate entity - [ ] A non-governmental organization (NGO) - [ ] A private company > **Explanation:** A derivative exchange is a legal corporate entity organized for the trading of derivative contracts. ## What is the primary purpose of the rules and regulations stipulated by derivative exchanges? - [x] To maintain fairness, order, and transparency - [ ] To restrict trading hours - [ ] To increase customization of contracts - [ ] To decentralize trading > **Explanation:** Derivative exchanges stipulate rules and regulations governing trading in order to maintain fairness, order, and transparency in the marketplace. ## What is an advantage of exchange-traded derivatives compared to OTC derivatives? - [ ] Higher customization - [ ] Lower standardization - [x] Addressing concerns around liquidity and default risk - [ ] Limited to specific financial institutions > **Explanation:** Exchange-traded derivatives evolved in response to OTC issues, including concerns around standardization, liquidity, and default risk. ## What is the name of Canada's derivative exchange? - [ ] Toronto Exchange - [ ] Vancouver Exchange - [x] Montréal Exchange - [ ] Calgary Exchange > **Explanation:** Canada’s derivative exchange is the Montréal Exchange (Bourse de Montréal). ## Which assets can be found trading on the Montréal Exchange? - [ ] Commodities only - [ ] Real estate derivatives only - [x] Options on stocks, indexes, and U.S. currency, as well as exchange-traded forwards (futures) on bonds, bankers' acceptances, and indexes - [ ] Cryptocurrencies only > **Explanation:** The Montréal Exchange lists options on stocks, indexes, and U.S. currency, as well as exchange-traded forwards (futures) on bonds, bankers’ acceptances, and indexes. ## Why did derivative exchanges evolve? - [ ] To increase customization options for contracts - [ ] To eliminate derivatives trading - [ ] To reduce the number of market participants - [x] In response to OTC issues such as standardization, liquidity, and default risk > **Explanation:** Derivative exchanges evolved to address concerns around standardization, liquidity, and default risk that were prevalent in the OTC derivatives market.

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Tuesday, July 23, 2024