A : The key motivation for such instruments is that they are useful in reallocating risk either across time or among individuals with different risk-bearing preferences.
A Comparison of Futures and Badla
|Expiration date unclear||Expiration date known|
|Spot market and different expiration dates are mixed up||Spot market and different expiration dates all trade distinct from each other|
|Identity of counterparty often known||Clearing corpn. is counterparty|
|Counterparty risk present||No counterparty risk|
|Badla financing is additional source of risk||No additional risk.|
|Badla financing contains default-risk premia||Financing cost at close to riskless thanks to counterparty guarantee|
|Asymmetry between long and short||Long and short are symmetric|
|Position can breakdown if borrowing/lending proves infeasible||You can hold till expiration date for sure, if you want to|
One kind of passing-on of risk is mutual insurance between two parties who face the opposite kind of risk. For example, in the context of currency fluctuations, exporters face losses if the rupee appreciates and importers face losses if the rupee depreciates. By forward contracting in the dollar-rupee forward market, they supply insurance to each other and reduce risk. This sort of thing also takes place in speculative position taking the person who thinks the price will go up is long a futures and the person who thinks the price will go down is short the futures.
Another style of functioning works by a risk adverse person buying insurance, and a risk tolerant person selling insurance. An example of this may be found on the options market : an investor who tries to protect himself against a drop in the index buys put options on the index, and a risk-taker sells him these options. Obviously, people would be very suspicious about entering into such trades without the institution of the clearing house which is a legal counterparty to both sides of the trade.
In these ways, derivatives supply a method for people to do hedging and reduce their risks. As compared with an economy lacking these facilities, it is a considerable gain.
The ultimate importance of a derivatives market hence hinges upon the extent to which it helps investors to reduce the risks that they face. Some of the largest derivatives markets in the world are on treasury bills (to help control interest rate risk), the market index (to help control risk that is associated with fluctuations in the stock market) and on exchange rates (to cope with currency risk).
Derivatives are also very convenient in terms of international investment. For example, Japanese insurance companies fund housing loans in the US by buying into derivatives on real estate in the US. Such funding patterns would be harder without derivatives.