September 10th, 2007, 11:44 am
The major practical tradeoff between exchange-traded products (e.g. futures) and OTC derivatives is cost vs. maintenance. Exchange traded stuff is cheaper (in terms of bid/offer spread) and more liquid (i.e. more visible) but some clients are just not interested in the work involved in maintaining the margin accounts and tailing hedges as time evolves. As well, because of contract standardization (dates, quantities etc.) there may be some basis risk involved in using exchange products. OTC products will usually provide a tighter fit but cost more.The major design tradeoff between linear products (bonds, swaps, forwards & futures) and options is the premium cost of options. By paying the option premium one can retain the upside of a position while removing the downside, much like buying insurance. There is of course no upfront cost in taking a futures position (apart from margin) but a futures position has a symmetrical payoff and thus takes away upside as well as downside.This kind of stuff was well described by Smithson et al in their book(s) "Managing Financial Risk", you know, the one presenting the "Lego" approach to financial engineering.