market, i.e. between two parties. The exchanges, such as the Chicago Board Options Exchange,
the London International Financial Futures Exchange or the Philadelphia Stock Exchange,
provide standardised options or standardised contracts with fixed maturity dates, strike prices
and contract sizes, although each exchange has its own contract specifications and trading
rules. The OTC market differs from the listed market in a similar way to how the spot and
forward foreign exchange market differs from currency futures markets. The OTC market
offers a customised, or tailor-made product, where the underlying amount, expiry date, strike
and even the option type (American or European) are a matter of negotiation. Thus, OTC
option specifications are much more flexible to fit specific requirements. In the listed market,
all such terms are standardised.
The OTC market is principally made up of banks and financial institutions, which make
option prices to their clients, and to each other. The exchange traded market is a public market,
where traders (who may be international banks) and private individuals own seats on the
exchange, and meet together in a “room”, “floor” or “pit” to trade currency options; whereby
in the OTC market, trading is a private deal between two parties. Similarly, in the OTC market,
settlement of option trades and the credit risk inherent in any deal is a matter between the
financial institution and its counterparty. This is usually for the option premium, which is paid
upfront by the buyer to the writer. The buyer, therefore, has a contingent claim on the writer
until the option expires. In the listed market, all transactions are processed through a clearing
house which acts as the counterparty to each deal, through a margining process (similar to
that used in all futures markets) and the clearing house guarantees the performance of the
contract.
EXCHANGE vs OVER-THE-COUNTER
Exchange traded options can be characterised by:
- Currencies are quoted mainly against dollars although recently some crosses have become available;
- Strike prices are at fixed intervals and quoted in dollars or cents per unit(s) of currency;
- Fixed contract sizes;
- Fixed expiry dates, generally at three-month intervals, e.g. delivery on the third Wednesday of March, June, September and December;
- Premium paid upfront and on the same day as the transaction;
- Options are usually American style.
The main advantage of the listed market is the public auction system. The trader or hedger
can be sure that the premium paid or received is publicly negotiated and displayed on market
screen and published the following day in the financial press and is therefore “fair”. By contrast,
in the OTC option market, where the contract is between, say, the bank and its client, the buyer
or writer has no way of telling whether the premium quoted is fair or otherwise. However,
it has to be remembered that there are some occasions where the public auctions system is
at a disadvantage to the OTC option market. For example, as liquidity is the greatest on the
exchanges in the near-the-money strikes with medium maturities (two or three months), it may
not be easy for a client holding an option position which has moved deep in- or far out-ofthe-
money to liquidate the position, particularly if the option had under a month to expire and
the quantity is quite large. By contrast, the OTC option market maker will usually make a
competitive price for the whole amount.
One other advantage of the traded option market is the clearinghouse system. In the OTC
option market, where banks trade with each other and their clients according to their mutual
assessment of credit risk, it is unfortunately very easy to “fill” a foreign exchange line. Once
credit lines are “full up”, not only is further option business between the two parties prohibited
but also so may be other traditional forms of business, for example spot or forward foreign
exchange. On the exchanges, however, the margining system allows market users the opportunity
to buy or write options in substantial amounts without affecting credit lines. Thus, credit
risk (the risk of the writer defaulting on the option) is therefore minimised and anonymity between
counterparties can be preserved. It should be noted that currency options on the Chicago
Mercantile Exchange (CME) are options on futures rather than options on the spot currency.
Hence, if a call is exercised, the buyer receives a long futures position rather than a spot position
and the opposite is the case for the buyer of a put. However, the margining process can be a
disadvantage, in that the mark-to-market system ensures that losses are taken on a daily basis
rather than on the expiration day of the option.
Over-the-counter options have the following characteristics:
- Strike rates, contract sizes and maturity are all subject to negotiation. An institution can structure its own option requirements, enabling it, for example, to make cross rate transactions;
- Maturities can be from several hours up to five years;
- The buyer has the direct credit risk on the writer;
- Only the counterparties directly involved know the price at which the option is dealt;
- The premium is normally paid with spot value from the transaction date with delivery of the underlying instrument also typically with spot value from expiry;
- Options can be either style but the majority are European style.
Read More: The Currency Options Market
