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FRM Part I · FRM Exam Part I · Exchanges and OTC Markets

A corporate treasurer needs a derivative whose notional amount, maturity date and underlying reference rate are tailored to match an irregular loan schedule. Which market is most suitable, and what is the main trade-off?

An OTC market is most suitable because terms can be tailored to the irregular loan schedule. The trade-off is bilateral counterparty credit risk, which remains unless the trade is centrally cleared or collateralized. Exchange contracts are standardized and cannot be freely customized.

  1. AAn exchange, because standardized contracts can be customized freely at no cost
  2. BAn OTC market, because contract terms can be tailored, but the trade carries bilateral counterparty credit risk unless cleared or collateralizedCorrect
  3. CAn exchange, because daily settlement removes the need for any standardization
  4. DAn OTC market, because OTC contracts are always guaranteed by a clearing house

Explanation

OTC contracts are negotiated bilaterally and can be customized to match exposures. The cost is counterparty credit risk, which exists unless the trade is centrally cleared or collateralized. Exchanges offer standardized terms, so they cannot match irregular schedules well.

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