Understanding Counterparty Risk in OTC Derivatives

Very Hard Derivative Markets And Instruments Over-the-counter Derivatives

In the context of Over-the-Counter (OTC) derivatives, it is crucial to understand the unique characteristics and risks associated with these instruments. OTC derivatives are traded directly between two parties, without the involvement of an exchange. This can lead to greater flexibility but also raises concerns surrounding liquidity, counterparty risk, and compliance with regulations. Consider the following situation:

A hedge fund enters into a customized interest rate swap agreement with a major bank. The swap is designed to exchange fixed interest rate payments for floating interest rate payments based on LIBOR. During the life of the swap, the interest rate environment changes significantly, and the hedge fund's counterparty expresses concern about its ability to fulfill its obligations.

Given this scenario, which of the following statements regarding OTC derivatives is most accurate?

OTC derivatives are standardized contracts that lead to high market liquidity.

OTC derivatives inherently involve greater counterparty risk due to the lack of intermediaries.

OTC derivatives are regulated more stringently than exchange-traded derivatives.

Hint

Submitted15.5K

Correct9.0K

% Correct58%