I am a B.Com student. Tell me why an exchange traded product is supposed to be superior to a product traded over the counter.

Sidanshu Gupta, Ghaziabad

A forward contract is between a party and his counter-party and hence bilateral in nature. That is why it is called an OTC. The advantages of an OTC has more than neutralised by disadvantages. Flexibility is the key advantage which an ETP naturally lacks owing to its very nature -standardisation.

In fact, the hallmark of OTC is customisation, the opposite of standardisation. A customised contract naturally gives a lot of scope for flexibility in terms of size and duration. But on the flip side, it also exposes one to the danger of counter-party risks. What if the counter-party reneges on the contract? It is here that ETP scores over OTC.

The exchange acts as the counter-party to both the buyer and the seller in the futures market, freeing both of the anxiety of counter-party risks. The downside is futures contracts being ETP is standardisation.

For example, the future contracts for rupee-dollar have a standard size of $ 1,000 necessitating several such contracts to be bought in case the exchange risk sought to be covered runs into millions of dollars. But the disadvantages are actually more in terms of inconvenience, and not substantive.

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(This article was published on April 24, 2011)
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