Page 16 - DCOM510_FINANCIAL_DERIVATIVES

Unit 1: Introduction to Derivatives

1.5 Exchange-traded vs. OTC Derivatives Markets Notes
Derivatives that trade on an exchange are called exchange traded derivatives, whereas privately
negotiated derivative contracts are called OTC contracts. The OTC derivatives markets have
witnessed rather sharp growth over the last few years, which have accompanied the
modernization of commercial and investment banking and globalization of financial activities.
The recent developments in information technology have contributed to a great extent to these
developments. While both exchange-traded and OTC derivative contracts offer many benefits,
the former have rigid structures compared to the latter. It has been widely discussed that the
highly leveraged institutions and their OTC derivative positions were the main cause of
turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to
market stability originating in features of OTC derivative instruments and markets.
The first exchange-traded financial derivatives emerged in 1970’s due to the collapse of fixed
exchange rate system and adoption of floating exchange rate systems. As the system broke
down currency volatility became a crucial problem for most countries. To help participants in
foreign exchange markets hedge their risks under the new floating exchange rate system, foreign
currency futures were introduced in 1972 at the Chicago Mercantile Exchange. In 1973, the
Chicago Board of Trade (CBOT) created the Chicago Board Options Exchange (CBOE) to facilitate
the trade of options on selected stocks. The first stock index futures contract was traded at Kansas
City Board of Trade. Currently the most popular stock index futures contract in the world is
based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties,
financial futures became the most active derivative instruments generating volumes many
times more than the commodity futures. Index futures, futures on T-bills and EuroDollar futures
are the three most popular futures contracts traded today. Other popular international exchanges
that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan,
MATIF in France, Eurex etc.

Did u know? The OTC derivatives have grown faster than the exchange-traded contracts in
the recent years.
Table 1.1 gives a bird’s eye view of these contracts as available worldwide on several exchanges

Table 1.1: Spectrum of Derivative Contracts Worldwide

Underlying Exchange Exchange OTC swap OTC forward OTC option
Asset traded traded
futures options
Equity Index future Index option Equity swap Back to back Stock options
Stock future Stock option repo Warrants
agreement
Interest rate Interest rate Options on Interest rate Forward rate Interest rate
futures futures swaps agreement caps, floors &
linked to collars.
MIBOR Swaptions
Credit Bond future Option on Credit Repurchase Credit
Bond future default swap agreement default
Total return option
swap
Foreign Currency Option on Currency Currency Currency
exchange future currency swap forward option
future

LOVELY PROFESSIONAL UNIVERSITY 11