Explanation:
Both reasons provided by Frau Schulz for preferring exchange trading over OTC markets are indeed correct.
The first reason highlights the central clearing feature of exchanges. This feature allows for the netting of all outstanding trades of a specific party. In other words, if a party has two opposite outstanding positions with two different parties, then both positions of the party will be offset or netted. This is a significant advantage of trading in exchanges as it simplifies the settlement process and reduces the credit risk associated with the trades.
The second reason emphasizes the reduction of counterparty risk and systemic risk when trading in exchanges. In bilateral clearing, which is common in OTC markets, the risk of a default by a market participant is borne entirely by its counterparties. However, if trades are cleared through a central counterparty (CCP), as is the case in exchanges, the risks are shared by all members of the CCP.
Q-828 Frau Schulz is the head of risk management at Frankfurt Money Bank. Her job is to understand the risk structure of a transaction and the risk of the market in which the transaction is carried out. She suggests that it is better to trade in exchanges than it is to trade in over-the-counter markets for the following reasons:
I. One reason for trading in exchange is the central clearing feature of exchange that allows the netting of all the outstanding trades of a specific party
II. Another reason for trading in exchanges is because it reduces counterparty risk and systemic risk
Which of the above-mentioned reasons for trading in exchanges rather than in OTC markets is/are incorrect?
A
Only I is incorrect
B
Only II is incorrect
C
Both reasons are incorrect
D
Both reasons are correct
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