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

Posted: 10 Jun 2008

See all articles by Lorne Switzer

Lorne Switzer

Concordia University, Quebec

Haibo Fan

Concordia University, Quebec

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.

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

JEL Classification: F31, G13, G15

Suggested Citation

Switzer, Lorne and Fan, Haibo, Interactions between Exchange Traded Derivatives and OTC Derivatives: Evidence for the Canadian Dollar Futures vs. OTC Markets. International Journal of Business, Vol. 13, No. 1, 2008, Available at SSRN: https://ssrn.com/abstract=1141311

Lorne Switzer (Contact Author)

Concordia University, Quebec ( email )

Haibo Fan

Concordia University, Quebec ( email )

Quebec H3G 1MB
Canada

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