WEEK 2 - OTC Markets, Dealers, Inter-dealer brokers

Question 1

What are the 2 ways people can trade in order driven markets?

Answer 1

Either adding new limit orders to the book; or placing market orders to buy or sell at the best prices on the book

Question 2

What are the 2 ways a order driven market can become?

Answer 2

A periodic or continuous auction

Question 3

What is meant by a periodic auction?

Answer 3

Only limit orders are allowed

in its pure version it is not possible to make a market orders at current market price

Question 4

What is meant by a continuous auction?

Answer 4

Traders can trade at any time when the market is open.

Buyers and sellers continuously place their orders and are matched on a continuous basis.

Question 5

What are the characteristics of an exchange?

Answer 5

1. The product or contract is standardised, supporting order-driven trading. Where there is a deep order–driven market, buyers and sellers can trade easily (most of the time) without the need for a market maker or dealer to provide liquidity
2. The exchange also plays a regulatory role, imposing rules on members and other traders to protect customers.

Question 6

What are the characteristics of OTC (Over the counter) Markets?

Answer 6

1. Dealers(market makers) play a central role, buying and selling is ‘quote driven’ at prices set by dealers rather than ‘order driven’ at prices determined by limit orders placed on the order book.
2. There is no need for the product or contract to be standardised. Dealers can vary their contracts – tailoring terms like maturity date or quantity to meet customer needs.

Question 7

What are the major OTC markets?

Answer 7

 Govt bonds

 Foreign exchange, (spot and forward)

 Money markets (loans of less than 12 months maturity)(trade in short term debt investments)

 Repo (secured money market borrowing using bond collateral) (form of short-term borrowing, mainly in government securities)

 Securities (equity) borrowing

 Forward rate agreements (FRAs) (lend money in the future determined on an intial agreed upon interest) and interest rate swaps

 Commodity forwards

 Commodity, foreign exchange interest rate options

 Single name and indexed credit default swaps

Question 8

What is the covered interest rate parity?

Answer 8

It holds that the interest rate differential between two currencies in the cash money markets should equal the differential between the forward and spot exchange rates.

Question 9

How do you calculate the interest rate parity?

Answer 9

(1+id)=F/S x (1+if)

Where:
id = The interest rate in the domestic currency or the base currency
if =The interest rate in the foreign currency or the quoted currency
S=The current spot exchange rate
F=The forward foreign exchange rate
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Question 10

What are the less active OTC Trading markets?

Answer 10

 Corporate bonds

 Sovereign bonds (government bonds issued in international not domestic markets)

 Syndicated loans

 So called ‘exotic’ derivatives, tailored to client needs

Question 11

What are the four classes that the OTC market be divided into?

Answer 11

Fixed Income:
Bonds, money markets, foreign exchange

Credit
(as a subdivision of fixed income, covering corporate bonds,sovereign bonds and credit derivatives);

Equity
(Cash equity and equity derivatives);

Commodities.

Question 12

What are the risks that the dealers/marker makers take in the OTC Market?

Answer 12

They are exposed to risk, as they accept customer orders and so they build up a position (or ‘inventory’) on one side of the market or the other, either a long position where they are exposed to risk of a price fall
or a short position where they are exposed to a risk of a price rise.

Question 13

What are the way dealers can manage this risk?

Answer 13

• Alter their ‘bid’ and ‘ask’ prices, lowering their ‘bid’ and ‘ask’ prices below those of other dealers, in order to sell more to clients and reduce a long position and increase the prices to reduce a short position
• Widening their ‘bid-ask’ spread outside of current market prices in order to reduce customer demand.
  In doing so prevents their exposure from rising further but lose profit opportunities as no longer take orders
• Use an interdealer broker
  So they can reduce both their positions.
  It is critical for these transactions to be anonymous

-Hedge their risk (take an offsetting position) in another OTC market or an exchange traded derivative market.

Question 14

What are the main issues due to the increasing financial regulation?

Answer 14

1. Regulators have imposed substantial ‘capital requirements’ to try to protect the system against market price and liquidity risks.
2. Regulators have become very concerned with ‘counterparty’ risk in OTC markets(This is the risk that a dealer or major client may default on their obligations)

To limit this risk they have asked firms to correct their market based valuations to allow for counterparty
risk (so called CVA or counterparty valuation adjustment) and to have contracts guaranteed by central counterparties.

3. Regulators have worried about the lack of transparency of OTC markets and asked market participants to report large amounts of data to trade repositories; and to reduce exposures by cancelling offsetting contracts (so called “compression”).
4. Regulators have also become concerned about dealers exploiting their clients, offering them prices that are much worse than those available in the market. Large fines have been imposed.