1.3 Types of Derivative Markets

1.1.1        Exchange-Traded Derivatives Markets

Derivatives traded on an exchange have the following characteristics:

• Standardized contract features such as:
  • Contract size
  • Expiration date
  • Underlying assets
• Exchange trades are guaranteed by a clearing house:
  • The clearing house requires a margin bond from the contract participants
• Transparency – More information disclosure requirements including price publication
• Central location and regulation – more regulated than OTC markets

Impact of the above characteristics on derivatives exchange markets

• Markets are more liquid
• Minimized credit risk among parties
• Enables clearing and settlement process
• Increased disclosure (transparency).
• Increased regulation compared to OTC markets.

1.1.2        Over-the-Counter (OTC) Derivatives Markets

The OTC derivatives markets comprise an informal network of market participants that are willing to create and trade virtually any type of derivative that can legally exist. The backbone of these markets is the set of dealers, which are typically banks. Thus it’s sometimes referred to as dealer market, since it involves dealers trading among themselves or with end users.

OTC markets enjoy more flexibility in contract size and asset specification as well as expiration date. OTC market is less liquid due to lack of standardization of contracts; less transparent transactions; customized (as opposed to standardized) transactions; have no central location; and are dominated by dealers.

Market makers make money through the bid-ask spread. Bids at low price and asks at a higher price.