Answer: Exchange-based derivatives can minimize counterparty credit risk through the use of netting and margin requirements.

## Explanation Let's analyze each option: **A. Exchange-based derivatives can be traded without incurring transaction costs.** - **Incorrect**: Exchange-based derivatives do incur transaction costs, including brokerage fees, exchange fees, and clearing fees. These costs are typically transparent but not zero. **B. Exchange-based derivatives offer flexibility in terms of customizing the hedging instrument to match the position that the firm wants to hedge.** - **Incorrect**: This is actually a disadvantage of exchange-based derivatives. They are standardized contracts with fixed terms, sizes, and expiration dates, which limits customization. OTC derivatives offer much greater flexibility for customization. **C. Exchange-based derivatives are typically more effective in reducing basis risk in a hedging transaction compared to bilateral OTC derivatives.** - **Incorrect**: Basis risk arises from imperfect correlation between the hedging instrument and the underlying exposure. Exchange-based derivatives, being standardized, may actually create more basis risk compared to customized OTC derivatives that can be tailored to match specific exposures. **D. Exchange-based derivatives can minimize counterparty credit risk through the use of netting and margin requirements.** - **Correct**: This is a key advantage of exchange-based derivatives. They use central clearing counterparties (CCPs) that: - Require initial and variation margin - Use daily mark-to-market and settlement - Employ multilateral netting arrangements - Provide mutualization of losses - This significantly reduces counterparty credit risk compared to bilateral OTC derivatives. The correct answer is **D** because counterparty risk mitigation through central clearing, margin requirements, and netting arrangements is a fundamental advantage of exchange-traded derivatives over OTC derivatives.

Author: LeetQuiz .