{"id":43383,"date":"2022-12-11T23:58:46","date_gmt":"2022-12-11T23:58:46","guid":{"rendered":"https:\/\/analystprep.com\/cfa-level-1-exam\/?p=43383"},"modified":"2026-01-10T06:32:22","modified_gmt":"2026-01-10T06:32:22","slug":"basic-features-of-derivative-markets","status":"publish","type":"post","link":"https:\/\/analystprep.com\/cfa-level-1-exam\/derivatives\/basic-features-of-derivative-markets\/","title":{"rendered":"Basic Features of Derivative Markets"},"content":{"rendered":"\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"VideoObject\",\n  \"name\": \"Derivative Instrument and Derivative Market Features (2024\/25 LI CFA\u00ae Exam \u2013 Derivatives Module 1)\",\n  \"description\": \"Explore the fundamentals of derivatives in this introductory module for the Level I CFA Program. This video covers key concepts, including the definition of derivative securities, their creation, and market structures like over-the-counter and exchange-traded derivatives. Learn about forward contracts, futures, options, and swaps, along with practical uses such as hedging, speculation, and arbitrage. Perfect for candidates starting their derivatives preparation.\",\n  \"uploadDate\": \"2022-11-24T00:00:00+00:00\",\n  \"thumbnailUrl\": \"https:\/\/img.youtube.com\/vi\/Kg70XKMoCz8\/maxresdefault.jpg\",\n  \"contentUrl\": \"https:\/\/www.youtube.com\/watch?v=Kg70XKMoCz8\",\n  \"embedUrl\": \"https:\/\/www.youtube.com\/embed\/Kg70XKMoCz8\",\n  \"duration\": \"PT26M20S\"\n}\n<\/script>\n\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"ImageObject\",\n  \"@id\": \"https:\/\/analystprep.com\/cfa-level-1-exam\/images\/exchange-traded-derivatives\",\n  \"contentUrl\": \"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Img_1-2-1536x1451.jpg\",\n  \"url\": \"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Img_1-2-1536x1451.jpg\",\n  \"caption\": \"Exchange-Traded Derivatives\",\n  \"width\": 1536,\n  \"height\": 1451,\n  \"copyrightNotice\": \"\u00a9 2024 AnalystPrep\",\n  \"acquireLicensePage\": \"https:\/\/analystprep.com\/license-info\",\n  \"creditText\": \"AnalystPrep Design Team\",\n  \"creator\": {\n    \"@type\": \"Organization\",\n    \"name\": \"AnalystPrep\"\n  }\n}\n<\/script>\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"QAPage\",\n  \"mainEntity\": {\n    \"@type\": \"Question\",\n    \"name\": \"Characteristics of the OTC derivatives market\",\n    \"text\": \"Which statement best describes the OTC derivatives market?\\n\\nA. Contracts are flexible, and there is a high degree of reporting to the regulatory authorities.\\n\\nB. Contracts are standardized, cleared, and settled through a centralized clearing house.\\n\\nC. Contracts are flexible, often cleared and settled between transacting parties with a low level of regulatory oversight.\",\n    \"answerCount\": 1,\n    \"acceptedAnswer\": {\n      \"@type\": \"Answer\",\n      \"text\": \"The correct answer is C.\\n\\nOTC derivatives contracts are flexible and are typically negotiated directly between counterparties. They are often cleared and settled bilaterally rather than through a centralized clearinghouse and generally involve a lower level of regulatory oversight compared to exchange-traded derivatives. In contrast, exchange-traded derivatives are standardized, centrally cleared, and subject to extensive regulatory reporting.\"\n    }\n  }\n}\n<\/script>\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"QAPage\",\n  \"mainEntity\": {\n    \"@type\": \"Question\",\n    \"name\": \"Choosing the appropriate derivatives market for hedging commercial contract risk\",\n    \"text\": \"Consider the following draft commercial contract extracted from Clap Company\u2019s records.\\n\\nContract date: Today\\nGoods seller: ABZ Limited, Japan\\nGoods buyer: Clap Company, USA\\nGoods description: Oil drilling machine\\nQuantity: Two\\nDelivery date: 150 days from the contract date\\nDelivery terms: Delivered by ferry. Costs to be paid by the buyer\\nPayment terms: The amount is payable by the buyer upon delivery\\nContract price: $17,525\\n\\nWhich derivative market should ABZ Limited most likely use to hedge its financial risk under this commercial contract?\\n\\nA. An exchange-traded market since it is standardized and transparent.\\n\\nB. An OTC market, since the contract can be customized to match ABZ\u2019s desired risk profile.\\n\\nC. The market with the best price regardless of whether it is an OTC or an exchange-traded market.\",\n    \"answerCount\": 1,\n    \"acceptedAnswer\": {\n      \"@type\": \"Answer\",\n      \"text\": \"The correct answer is B.\\n\\nAn over-the-counter (OTC) market allows derivatives contracts to be customized to closely match the specific risk exposure faced by ABZ Limited. In this case, the delivery date of 150 days and the exact contract price make it difficult to find a suitable standardized contract in an exchange-traded market. OTC derivatives are therefore better suited for hedging this type of bespoke commercial risk.\\n\\nOptions A and C are incorrect because exchange-traded markets generally offer standardized contracts that are unlikely to align precisely with ABZ Limited\u2019s exposure, and price alone is not sufficient if the contract terms do not adequately hedge the underlying risk.\"\n    }\n  }\n}\n<\/script>\n\n\n\n\n<iframe loading=\"lazy\" width=\"560\" height=\"315\" src=\"https:\/\/www.youtube.com\/embed\/Kg70XKMoCz8?si=vw92AmvcxS9zID1z\" title=\"YouTube video player\" frameborder=\"0\" allow=\"accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share\" referrerpolicy=\"strict-origin-when-cross-origin\" allowfullscreen><\/iframe>\n\n\n\n<h2 class=\"wp-block-heading\">Over-the-Counter (OTC) Derivative Markets<\/h2>\n\n\n\n<p>OTC derivative markets can be formal institutions such as NASDAQ or an information connection of parties who buy from and sell to one another.<\/p>\n\n\n\n<p>In OTC derivative markets, <strong>derivatives end-users <\/strong>enter contracts with <strong>dealers <\/strong>or a financial intermediary such as a bank. The dealers (also regarded as the market markers) engage in bilateral transactions to transfer risk to other parties.<\/p>\n\n\n\n<p>Terms of OTC can be modified to match a desired risk exposure profile. This is a beneficial feature to derivative end users who want to hedge existing or expected exposure.<\/p>\n\n\n\n<div style=\"margin: 0 0 20px 0;\">\n  <a\n    href=\"https:\/\/analystprep.com\/free-trial\/\"\n    target=\"_blank\"\n    rel=\"noopener noreferrer\"\n    style=\"\n      display: inline-block;\n      border: 2px solid #1e63ff;\n      color: #1e63ff;\n      background: #ffffff;\n      padding: 10px 14px;\n      border-radius: 10px;\n      font-weight: 500;\n      line-height: 1.35;\n      text-decoration: none;\n    \"\n  >\n    Want to practice the basic features of derivative markets tested on CFA Level I? Try AnalystPrep\u2019s free trial now.\n  <\/a>\n<\/div>\n\n\n\n<h2 class=\"wp-block-heading\">Exchange-Traded Derivative (ETD) Markets<\/h2>\n\n\n\n<p>In ETD markets, derivatives are traded in more formal and standardized contracts, promoting higher liquidity and transparency. Such derivatives include futures, options, and other financial contracts at the exchange.<\/p>\n\n\n\n<p>The exchange determines the terms and conditions, including the size of each contract, type, quality, and location of the underlying.<\/p>\n\n\n\n<p>The exchange members consist of dealers (market markers) who are prepared to buy at one price and sell at a higher price. If they cannot find counterparties to trade, risk takers such as speculators may be willing to assume an exposure in the underlying.<\/p>\n\n\n\n<p>Exchange-traded derivatives have standardized terms and conditions. As such, clearing and settlement are done efficiently.<\/p>\n\n\n\n<p><strong>Clearing <\/strong>is a process where the exchange\/central counterparty verifies the execution of a transaction, exchange of payments, and records of the participants. On the other hand, <strong>settlement <\/strong>refers to the payment of final amounts and\/or delivery of securities or physical commodities between the counterparties based upon exchange rules.<\/p>\n\n\n\n<p>Exchange-traded derivatives demand collateral on deposit upon initiation and during the life of a contract to reduce counterparty risk. The deposit is paid through a financial intermediary, which assures counterparty default.<\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img loading=\"lazy\" decoding=\"async\" width=\"1024\" height=\"967\" src=\"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Img_1-2-1024x967.jpg\" alt=\"Image Showing Exchange-Traded Derivatives\" class=\"wp-image-43702\" srcset=\"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Img_1-2-1024x967.jpg 1024w, https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Img_1-2-300x283.jpg 300w, https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Img_1-2-768x725.jpg 768w, https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Img_1-2-1536x1451.jpg 1536w, https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Img_1-2-400x378.jpg 400w, https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Img_1-2-24x24.jpg 24w, https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Img_1-2.jpg 1590w\" sizes=\"auto, (max-width: 1024px) 100vw, 1024px\" \/><\/figure>\n\n\n<p><!-- wp:image {\" id\":43386,\"sizeslug\":\"large\",\"linkdestination\":\"none\"}=\"\" --=\"\">\n\n\n\n\n\n\n\n\n\n\n<figure class=\"wp-block-image size-large\"><img loading=\"lazy\" decoding=\"async\" width=\"1024\" height=\"846\" class=\"wp-image-43386\" src=\"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Pic-2-1024x846.png\" alt=\"\" srcset=\"https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Pic-2-1024x846.png 1024w, https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Pic-2-300x248.png 300w, https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Pic-2-768x634.png 768w, https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Pic-2-1536x1269.png 1536w, https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Pic-2-400x330.png 400w, https:\/\/analystprep.com\/cfa-level-1-exam\/wp-content\/uploads\/2022\/12\/Pic-2.png 1835w\" sizes=\"auto, (max-width: 1024px) 100vw, 1024px\" \/><\/figure>\n\n\n\n\n\n\n\n\n\n\n<!-- \/wp:post-content --> <!-- wp:heading --><\/p>\n<h2>Differences between Over-the-Counter (OTC) Derivative and Exchange-Traded Derivative (ETD) Markets<\/h2>\n<p><!-- \/wp:heading --> <!-- wp:list --><\/p>\n<ul>\n<li>OTC offers more flexibility and customizability.<\/li>\n<li>OTC is less transparent than ETD.<\/li>\n<li>OTC involves more counterparty risk, and it is less liquid than ETD.<\/li>\n<\/ul>\n<p><!-- \/wp:list --><\/p>\n<blockquote>\n<h2>Question 1<\/h2>\n<p>Which statement <em>best<\/em> describes the OTC derivatives market?<\/p>\n<p>A. Contracts are flexible, and there is a high degree of reporting to the regulatory authorities.<\/p>\n<p>B. Contracts are standardized, cleared, and settled through a centralized clearing house.<\/p>\n<p>C. Contracts are flexible, often cleared and settled between transacting parties with a low level of regulatory oversight.<\/p>\n<h3>Solution<\/h3>\n<p><strong>The correct answer is C<\/strong>.<\/p>\n<p>Exchange-traded derivative contracts are standardized, cleared, and settled through a centralized clearinghouse and accompanied by a high level of regulatory reporting. OTC contracts are far more flexible and less regulated.<\/p>\n<h2>Question 2<\/h2>\n<p>Consider the following draft commercial contract extracted from Clap company\u2019s records.<\/p>\n<p>$$\\small{\\begin{array}{l|l} \\text{Contract date} &amp; \\text{Today} \\\\ \\hline<br \/>\\text{Goods seller} &amp; \\text{ABZ Limited, Japan} \\\\ \\hline \\text{Goods buyer} &amp; \\text{Clap Company, USA} \\\\ \\hline \\text{Goods description} &amp; \\text{Oil drilling machine} \\\\ \\hline \\text{Quantity} &amp; \\text{Two} \\\\ \\hline<br \/>\\text{Delivery date} &amp; \\text{150 days from the contract date} \\\\ \\hline \\text{Delivery terms} &amp; {\\text{Delivered by ferry. Costs to be paid}\\\\ \\text{by the buyer}} \\\\ \\hline \\text{Payment terms} &amp; \\text{The amount is payable by the buyer upon delivery} \\\\ \\hline \\text{Contract price} &amp; \\$17,525\\end{array}}$$<\/p>\n<p>Which derivative market should ABZ Limited <em>most likely<\/em> use to hedge its financial risk under this commercial contract?<\/p>\n<p>A. An exchange-traded market since it is standardized and transparent.<\/p>\n<p>B. An OTC market, since the contract can be customized to match ABC\u2019s desired risk profile.<\/p>\n<p>C. The market with the best price regardless of whether it is an OTC or an exchange-traded market.<\/p>\n<h3>Solution<\/h3>\n<p>The correct answer is <strong>B<\/strong>.<\/p>\n<p>An over-the-counter market allows the customization of risk to suit a client\u2019s risk exposure profile.<\/p>\n<p>It would be difficult for ABZ Limited to find a contract that matches the desired 150 days from contract date delivery and the exact contract price in an exchange-traded market.<\/p>\n<p><strong>A and C are incorrect<\/strong>. As seen above, the over-the-counter market is the best-suited market for ABZ Limited.<\/p>\n<\/blockquote>\n<p><!-- wp:html --><\/p>\n<div style=\"text-align: center; margin: 32px 0;\">\n  <a\n    href=\"https:\/\/analystprep.com\/free-trial\/\"\n    target=\"_blank\"\n    rel=\"noopener noreferrer\"\n    style=\"\n      display: inline-block;\n      background-color: #1e63ff;\n      color: #ffffff;\n      padding: 12px 26px;\n      border-radius: 12px;\n      font-weight: 600;\n      font-size: 16px;\n      text-decoration: none;\n    \"\n  ><br \/>\n    Start Free Trial \u2192<br \/>\n  <\/a><\/p>\n<div style=\"margin-top: 10px; font-size: 14px; color: #374151;\">\n    Practice CFA Level I derivatives questions covering market participants, contract features, and exchange traded versus OTC markets.\n  <\/div>\n<\/div>\n<p><!-- \/wp:html --><\/p>","protected":false},"excerpt":{"rendered":"<p>Over-the-Counter (OTC) Derivative Markets OTC derivative markets can be formal institutions such as NASDAQ or an information connection of parties who buy from and sell to one another. In OTC derivative markets, derivatives end-users enter contracts with dealers or a&#8230;<\/p>\n","protected":false},"author":13,"featured_media":43384,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[10],"tags":[],"class_list":["post-43383","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-derivatives","blog-post","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Basic Features of Derivative Markets | CFA Level 1<\/title>\n<meta name=\"description\" content=\"Understand the basic features of derivatives markets, including exchange-traded derivatives and bilateral contracts. 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