Exchange Traded versus Overthe Counter Options

Options, like other financial instruments, may be traded either on an organized exchange or in the over-the-counter (OTC) market. The advantages of an exchange-traded option are as follows. First, the exercise price and expiration date of the contract are standardized. Second, as in the case of futures contracts, the direct link between buyer and seller is severed after the order is executed because of the interchange-ability of exchange-traded options. The clearinghouse associated with the exchange where the option trades performs the same function in the options market that it does in the futures market. Finally, the transactions costs are lower for exchange-traded options than for OTC options.

The higher cost of an OTC option reflects the cost of customizing the option for the many situations where a corporation seeking to use an option to manage risk needs to have a tailor-made option because the standardized exchange-traded option does not satisfy its objectives. Some commercial and investment and banking firms act as principals as well as brokers in the OTC options market. OTC options are sometimes referred to as dealer options. While an OTC option is less liquid than an exchange-traded option, this is typically not of concern to the user of such an option. Most corporations who use OTC options do so as part of a financing strategy or price protection against unfavorable changes in prices of its inputs or exchange rates.

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