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FRM Part I · FRM Exam Part I · Introduction to Derivatives

Two parties enter a bilateral OTC forward. Which is the main reason a bilateral OTC derivative typically carries more liquidity risk and difficulty to unwind than an exchange-traded futures contract, ignoring any central clearing?

Bilateral OTC contracts are customized and not fungible, so unwinding generally needs the original counterparty's agreement or a new offsetting trade that leaves both exposures outstanding. Exchange-traded futures are standardized and can simply be offset with an opposite trade.

  1. AOTC contracts are always marked to market daily with cash settlement
  2. BClosing out generally requires agreement with the original counterparty or a new offsetting contract, since the contract is not standardized or fungibleCorrect
  3. COTC contracts have no legal documentation
  4. DOTC contracts must be held until maturity by regulation

Explanation

Because bilateral contracts are customized and not fungible, reversal needs the counterparty's agreement (termination or assignment) or an offsetting trade that leaves two exposures. Exchange contracts can be offset with an opposite trade. Documentation such as ISDA agreements does exist, and no regulation forces holding to maturity.

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