THE FINANCIAL RISK MANAGEMENT

Running head: FINANCIAL RISK MANAGEMENT
Financial risk management
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FINANCIAL RISK MANAGEMENT1
Exchange traded derivatives and over-the-counter derivatives
In recent years growth in the trading volume for contract of exchange traded derivatives
has been speedy that is exceeding 20% per year in global basis on the basis of estimates from
(BIS) Bank for International Settlements. However, primary venue for trading the currency
derivatives is OTC market that is dominated by the commercial banks. In accordance with the
survey carried out in 2004 by BIS Triennial, daily average volume in currency products under
exchange traded markets totalled 23 billion as compared to $1345 billion OTC products (Bis.org,
2019).
Derivative is the financial instrument that generates the value from performance of
fundamental asset or security. This underlying asset or security can be anything including bonds,
stocks, currency, interest rate and commodities. Primarily there are 2 types of markets – spot
market or cash market and derivative market. Derivatives are considered to be similar as
insurance contracts as both the instruments assists to transfer risks among 2 parties. Put option
with underlying instrument is also same as the insurance contract. Likewise other financial
instruments, derivatives also require 2 parties for the purpose of trading – long party and short
party (Pernell, Jung & Dobbin, 2017).
Exchange traded derivatives (ETD) – this is traded in the regulated exchange and value for
which is depended on value of any other asset. To put simply, these are the derivatives those are
traded under regulated manner. ETDs have become popular owing to its advantages as compared
to OTC derivatives like liquidity, standardization and abolition of the default risk. Options and
futures are 2 among the most popular ETDs. These can be used for hedging exposures or

FINANCIAL RISK MANAGEMENT2
speculating on wide range of the financial assets such as equities, commodities, interest rates and
currencies (Knaack, 2015).
Over the counter derivatives (OTC) – OTCs are traded among 2 parties which is a bilateral
negotiation without the requirement of going through the exchange or through any other
intermediaries. This term is used for referring stocks those are traded through the network of
dealer and not through the centralized exchange. These are also termed as unlisted stocks where
securities are traded through broker-dealers through direct negotiations. Hence, OTCs can be
negotiated as well as customized to match exact return and risk required by each party. Although
this kind of derivatives provides flexibility, it is exposed to credit risk as no clearing corporation
is there (Ge, 2016).
Key differences among OTC and ETD –
Under a market with the exchange trading, the transactions get completed through the
centralized source. To be more specific, 1 party performs as the mediator that connects the
sellers and buyers. Specific numbers of traders are there that trades on one centralized system.
This scenario places high power on the mediator and the same is the major disadvantage for this
kind of trading. Encouraging aspect to this is that it enables better enforcement of transaction and
stricter security. Under such market products can be standardized and the same can also be
guaranteed that products and goods are in conformity with the trading terms (Abdel-Khalik &
Chen, 2015). Conversely, OTC markets generally are decentralized. Here, many mediators are
there who compete for linking the buyers and sellers. Major advantage of this is that is assures
that the costs for the intermediary services are as small as possible. On the other hand, the
obvious disadvantage is these markets usually are deregulated and are more prone to the