Derivative contracts - exchange traded contracts

11 November 2005

Derivative Contracts – sometimes exchange traded contracts are more practical.

As students of treasury, most of us learned about the differences of exchange traded contracts and over the counter (OTC) contracts.

Having learned the theory, most of us never have any need for it. In practice, almost all of the derivative contracts that corporates deal in are OTC contracts negotiated with one or more banks. However, I was recently reminded of the utility of exchange traded contracts after a recent conversation with a banker.

We were discussing the treasury needs of smaller companies. The practical difficulty is that as transaction sizes diminish, it becomes increasingly unattractive for a bank to deal, simply due to the internal procedures required such as credit approval. For example, this bank would never agree to write a currency option for an underlying amount of foreign currency of less than about £300,000 equivalent. That would leave small company which need a currency option over say $100,000 with nowhere to go.

I appreciate that this is unlikely to be relevant to most readers of this blog. However, most of us have friends at smaller companies.

If a smaller company needs to manage its risks by transacting a currency option or forward, then it should consider exchange traded instruments. There are practical limitations, such as fixed expiry months and standardised lot sizes. However, given a choice between no instrument at all, (because the amounts are too small for a bank to deal) or having a less than perfect match with the risk to be hedged, it may be better to go for the imperfect solution.

As an example, the Philadelphia Stock Exchange offers US dollar v sterling options with a contract size of only £31,250. While there is the need to establish a brokerage account, once this is done a smaller company is able to use exchange traded options and futures to manage its risks on transactions that would be sub-scale for a bank. Further, the exchange traded nature means that the pricing for the instruments is always a market price. In the case of OTC derivatives, not only does a small company have to persuade one bank to deal, it also needs to persuade others to quote a price,  as otherwise it has no way of knowing whether the bank quote received is reasonable.

This article was originally written and published by Mohammed Amin.


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