Thursday, 24 April 2008

What's so great about exchanges?

We are in the middle of a furore about the OTC markets: see for instance here for John Dizard in the FT. Now I can't argue that the OTC markets are perfect. But just moving an illiquid, hard-to-value contract from OTC to exchange-traded won't necessarily make it any more liquid or easier to value. Indeed it may make things worse because a stale or bad mark from the exchange might be credited with a spurious authority. At least with the OTC market you get a sense of the real liquidity of a product.

Lest you think I am making all of this up, here, courtesy of Yahoo (the Bloomberg screens have more data and hence make the point less well) are the June equity options on Dow Chemical, a large liquid U.S. stock.

Notice the volumes: for the far out of the money options, they are tiny. The quotes on the at the money's are fine, as are the slightly out of the money options. But do you really believe that the prices of the 30, 55 or 60 strike calls are correct given the low volume and low open interest? And if these issues arise on something as well known as Dow, imagine what the exchange prices for far out of the money options on less liquid stocks are like, and then tell me putting CDS trading on exchange will cure all the market's ills.

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