As was seen in Chapter 1, derivatives markets are now so large that they exert a significant effect on the overall economy. A large number of people now directly or indirectly earn (or lose) money from trading on derivatives and for them, the interesting issue is ‘how do these markets work’. This book is more concerned with the existential question of ‘why should they exist’ and the policy question of ‘how should they work’. To that end, this chapter examines the economic (as opposed to financial) functions, which derivatives markets perform. The term ‘economic functions’ is used to imply socially useful functions, i.e., those that promote welfare, and some economists have used the term ‘social functions’ for these.

The ‘conventional’ view in the literature of economics has been that derivatives markets perform several useful functions. The function on which there is the least disagreement is the hedging or risk transference function.

Hedging or risk transfer: The primary function

The primary economic function of most derivatives markets, especially the simple derivatives, is the hedging function also known as the risk-shifting or risk transference function. Derivatives enable market participants to hedge themselves (i.e., indemnify themselves) from adverse price movements in the underlying in which they face a price risk. The ability to hedge enables them to transfer unwanted risk to others who are willing to bear that risk.

In futures markets, hedging is accomplished by buying or selling the futures contract. If a hedger (say, a textile mill owner requiring cotton) wants to protect himself against a rising price, he would buy the futures contract.