Academic journal article International Journal of Business

Interactions between Exchange Traded Derivatives and OTC Derivatives: Evidence for the Canadian Dollar Futures vs. OTC Markets

Academic journal article International Journal of Business

Interactions between Exchange Traded Derivatives and OTC Derivatives: Evidence for the Canadian Dollar Futures vs. OTC Markets

Article excerpt

ABSTRACT

The OTC market, which is dominated by commercial banks, has been alleged to pose a considerable barrier to the growth of exchange traded derivatives. If banks substitute OTC products to their captive clients, transactions costs for hedging could be excessive relative to those of exchange traded products. The dominant position of OTC currency derivatives products relative to exchange traded derivatives could be troublesome for a number of other reasons including lack of transparency, with insufficient disclosure at the entity level. Lower transactions costs and trader anonymity provide relative advantages to futures markets for conveying information of informed traders/speculators. This paper tests the informational advantage hypothesis for foreign exchange futures contracts relative to OTC contracts using actual OTC foreign exchange derivative trading data. In addition, we test for substitutability vs. complementarity of OTC products against foreign exchange futures products. We examine monthly trading volume and volatility estimates of the OTC market and the futures market for the Canadian Dollar over the period January 1998 to September 2005. Futures trading activity is shown to provide leading information to the OTC markets, suggesting that there are informational advantages to futures markets. Trading volume in the OTC (exchange traded) market shows uni-(bi-) directional Granger causality to the volatility to both spot and futures markets, consistent with greater responsiveness of the exchange traded (OTC) market to changes in market-wide (idiosyncratic)risk. Regression tests support substitutability between the foreign exchange futures market and the OTC derivatives market.

JEL: F31, G13, G15

Keywords: OTC and exchange traded derivatives; Foreign exchange; Volume and volatility causality; Substitutability vs. complementarity

I. INTRODUCTION

In recent years, the growth in trading volume of exchange-traded derivatives contracts has been rapid, exceeding 20% per year globally, based on estimates of the Bank for International Settlements (BIS). However, the primary trading venue for currency derivatives is the OTC market, which is dominated by commercial banks. According to the 2004 BIS Triennial survey, the average daily volume in exchange traded currency products totalled 23 billion compared to $1,345 billion in over-the-counter products. (1) Figure 1 highlights the size differential of OTC market vs. the Futures market for Canadian dollars. Over the period 1998-2005, the notional value of exchange traded Canadian dollar futures represents less than 5% of their OTC derivative counterparts.

[FIGURE 1 OMITTED]

The pre-eminent position of OTC derivative products relative to exchange traded derivatives could be troublesome for a number of reasons. First, such products lack transparency, with insufficient disclosure at the entity level. Insufficient transparency and surveillance in OTC products could give rise to manipulation of markets, or greater departures from fair value of trades. Commercial banks may steer their clients to OTC products with higher relative transactions costs for their captive clients. (2) Furthermore, counterparty risk exposures are far greater for OTC products than for exchange traded products, owing to daily variation settlements by exchange clearing houses for the latter. Greenspan (1999) suggests that such risk may represent as much as 6% of banks' total assets. Transactions cost advantages, however, would favor futures markets as the optimal venue for conveying information of informed traders/speculators.

Due to a lack of data, assessing the interactions between OTC and exchange traded derivative products has been difficult, at best. Some work has been done on the relationships between exchange traded futures vs. spot markets (for example, Chan et al. (1991); Chan (1992), Ng and Pirrong, (1996), Koutmos and Tucker (1996), and Min and Najand (1999)). …

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