Understanding Counterparty Risk in OTC Derivatives

Hard Derivative Markets And Instruments Over-the-counter Derivatives

In the context of Over-the-Counter (OTC) derivatives, various aspects differentiate them from exchange-traded derivatives. One significant characteristic is the nature of the counterparty involved in the transaction. OTC derivatives are primarily traded between two parties without a central exchange. This allows for greater customization of contracts but also introduces specific risks related to counterparty defaults.

Consider the following statements regarding the risks associated with OTC derivatives:

1. They are subject to less regulatory oversight compared to exchange-traded derivatives.

2. Counterparty risk is a significant concern because there is no central clearinghouse involved.

3. The confidentiality of transactions in the OTC market can lead to a lack of transparency in pricing.

Based on these characteristics, which one of the following is TRUE regarding OTC derivatives?

OTC derivatives are always more liquid than exchange-traded derivatives.

OTC derivatives are typically easier to price due to standardized contracts.

OTC derivatives face higher counterparty risk than exchange-traded derivatives.

Hint

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