Over-the-Counter Derivatives Markets
Because of the customization of OTC derivatives, there is a tendency to think that the OTC market is less liquid than the exchange market. That is not necessarily true. Many OTC instruments can easily be created and then essentially offset by doing the exact opposite transaction, often with the same party. For example, suppose Corporation A buys an OTC derivative from Dealer B. Before the expiration date, Corporation A wants to terminate the position. It can return to Dealer B and ask to sell a derivative with identical terms. Market conditions will have changed, of course, and the value of the derivative will not be the same, but the transaction can be conducted quite easily with either Corporation A or Dealer B netting a gain at the expense of the other. Alternatively, Corporation A could do this transaction with a different dealer, the result of which would remove exposure to the underlying risk but would leave two transactions open and some risk that one party would default to the other. In contrast to this type of OTC liquidity, some exchange-traded derivatives have very little trading interest and thus relatively low liquidity. Liquidity is always driven by trading interest, which can be strong or weak in both types of markets.
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