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

A risk manager compares the over-the-counter (OTC) derivatives market with exchange-traded derivatives. Which statement best describes a key structural difference between the two?

OTC contracts are customized and bilaterally negotiated, so each party is exposed to the other's default unless the trade is centrally cleared or collateralized. Exchange-traded contracts are standardized and backed by a clearing house, which is why the reversed descriptions in the other options are wrong.

  1. AOTC contracts are customized bilaterally between counterparties, so they carry counterparty credit risk unless cleared or collateralizedCorrect
  2. BOTC contracts are standardized and guaranteed by the exchange, which removes counterparty credit risk
  3. CExchange-traded contracts are privately negotiated and can have any maturity or notional the parties choose
  4. DExchange-traded contracts are settled only through bilateral netting agreements between dealers

Explanation

OTC derivatives are negotiated privately and tailored to the needs of the parties, so each side bears the other's default risk unless central clearing or collateral is used. Exchange-traded contracts are standardized and normally backed by a clearing house. The options that reverse these features are incorrect.

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