Derivatives. Pirie Wendy L.

itself. Of course, that begs the question of why the company could not have laid off the risk itself and avoided the dealer. Indeed, some can and do, but laying off risk is not simple. Unable to find identical offsetting transactions, dealers usually have to find similar transactions with which they can lay off the risk. Hedging one derivative with a different kind of derivative on the same underlying is a similar but not identical transaction. It takes specialized knowledge and complex models to be able to do such transactions effectively, and dealers are more capable of doing so than are ordinary companies. Thus, one might think of a dealer as a middleman, a sort of financial wholesaler using its specialized knowledge and resources to facilitate the transfer of risk. In the same manner that one could theoretically purchase a consumer product from a manufacturer, a network of specialized middlemen and retailers is often a more effective method.

      Because of the customization of OTC derivatives, there is a tendency to think that the OTC market is less liquid than the exchange market. That is not necessarily true. Many OTC instruments can easily be created and then essentially offset by doing the exact opposite transaction, often with the same party. For example, suppose Corporation A buys an OTC derivative from Dealer B. Before the expiration date, Corporation A wants to terminate the position. It can return to Dealer B and ask to sell a derivative with identical terms. Market conditions will have changed, of course, and the value of the derivative will not be the same, but the transaction can be conducted quite easily with either Corporation A or Dealer B netting a gain at the expense of the other. Alternatively, Corporation A could do this transaction with a different dealer, the result of which would remove exposure to the underlying risk but would leave two transactions open and some risk that one party would default to the other. In contrast to this type of OTC liquidity, some exchange-traded derivatives have very little trading interest and thus relatively low liquidity. Liquidity is always driven by trading interest, which can be strong or weak in both types of markets.

      OTC derivative markets operate at a lower degree of regulation and oversight than do exchange-traded derivative markets. In fact, until around 2010, it could largely be said that the OTC market was essentially unregulated. OTC transactions could be executed with only the minimal oversight provided through laws that regulated the parties themselves, not the specific instruments. Following the financial crisis that began in 2007, new regulations began to blur the distinction between OTC and exchange-listed markets. In both the United States (the Wall Street Reform and Consumer Protection Act of 2010, commonly known as the Dodd–Frank Act) and Europe (the Regulation of the European Parliament and of the Council on OTC Derivatives, Central Counterparties, and Trade Repositories), regulations are changing the characteristics of OTC markets.

      When the full implementation of these new laws takes place, a number of OTC transactions will have to be cleared through central clearing agencies, information on most OTC transactions will need to be reported to regulators, and entities that operate in the OTC market will be more closely monitored. There are, however, quite a few exemptions that cover a significant percentage of derivative transactions. Clearly, the degree of OTC regulation, although increasing in recent years, is still lighter than that of exchange-listed market regulation. Many transactions in OTC markets will retain a degree of privacy with lower transparency, and most importantly, the OTC markets will remain considerably more flexible than the exchange-listed markets.

      EXAMPLE 2 Exchange-Traded versus Over-the-Counter Derivatives

      1. Which of the following characteristics is not associated with exchange-traded derivatives?

      A. Margin or performance bonds are required.

      B. The exchange guarantees all payments in the event of default.

      C. All terms except the price are customized to the parties’ individual needs.

      2. Which of the following characteristics is associated with over-the-counter derivatives?

      A. Trading occurs in a central location.

      B. They are more regulated than exchange-listed derivatives.

      C. They are less transparent than exchange-listed derivatives.

      3. Market makers earn a profit in both exchange and over-the-counter derivatives markets by:

      A. charging a commission on each trade.

      B. a combination of commissions and markups.

      C. buying at one price, selling at a higher price, and hedging any risk.

      4. Which of the following statements most accurately describes exchange-traded derivatives relative to over-the-counter derivatives? Exchange-traded derivatives are more likely to have:

      A. greater credit risk.

      B. standardized contract terms.

      C. greater risk management uses.

      Solution to 1: C is correct. Exchange-traded contracts are standardized, meaning that the exchange determines the terms of the contract except the price. The exchange guarantees against default and requires margins or performance bonds.

      Solution to 2: C is correct. OTC derivatives have a lower degree of transparency than exchange-listed derivatives. Trading does not occur in a central location but, rather, is quite dispersed. Although new national securities laws are tightening the regulation of OTC derivatives, the degree of regulation is less than that of exchange-listed derivatives.

      Solution to 3: C is correct. Market makers buy at one price (the bid), sell at a higher price (the ask), and hedge whatever risk they otherwise assume. Market makers do not charge a commission. Hence, A and B are both incorrect.

      Solution to 4: B is correct. Standardization of contract terms is a characteristic of exchange-traded derivatives. A is incorrect because credit risk is well-controlled in exchange markets. C is incorrect because the risk management uses are not limited by being traded over the counter.

      4. TYPES OF DERIVATIVES

      As previously stated, derivatives fall into two general classifications: forward commitments and contingent claims. The factor that distinguishes forward commitments from contingent claims is that the former obligate the parties to engage in a transaction at a future date on terms agreed upon in advance, whereas the latter provide one party the right but not the obligation to engage in a future transaction on terms agreed upon in advance.

      4.1. Forward Commitments

      Forward commitments are contracts entered into at one point in time that require both parties to engage in a transaction at a later point in time (the expiration) on terms agreed upon at the start. The parties establish the identity and quantity of the underlying, the manner in which the contract will be executed or settled when it expires, and the fixed price at which the underlying will be exchanged. This fixed price is called the forward price.

      As a hypothetical example of a forward contract, suppose that today Markus and Johannes enter into an agreement that Markus will sell his BMW to Johannes for a price of €30,000. The transaction will take place on a specified date, say, 180 days from today. At that time, Markus will deliver the vehicle to Johannes’s home and Johannes will give Markus a bank-certified check for €30,000. There will be no recourse, so if the vehicle has problems later, Johannes cannot go back to Markus for compensation. It should be clear that both Markus and Johannes must do their due diligence and carefully consider the reliability of each other. The car could have serious quality issues and Johannes could have financial problems and be unable to pay the €30,000. Obviously, the transaction is essentially unregulated. Either party could renege on his obligation, in response to which the other party could go to court, provided a formal contract exists and is carefully written. Note finally that one of the two parties is likely to end up gaining and the other losing, depending on the secondary market price of this type of vehicle at expiration of the contract.

      This example is quite simple but illustrates the essential elements of a forward contract. In the financial world, such contracts are very carefully written, with legal provisions that guard against fraud and require extensive credit checks. Now let us take a deeper look at the characteristics of forward contracts.

4.1.1 Forward Contracts

      The