There may or may not be free lunches in the world, but there are clearly no free derivatives, or derivatives completely devoid of any kind of risk. Consider the recent case of financial institutions using leverage to sell masala bonds in the international market by packaging them as a derivative. Masala bonds allow Indian institutions to raise debt in other countries, but the debt is denominated in rupee. As a result, the Indian issuer doesn't have to face currency risk since masala bonds are denominated in rupee and the foreign investor makes more than 7-8% returns, which is unthinkable in many countries. When financial institutions create a derivative out of masala bond, they tell the investor to put in a small portion of the bond's price (a fourth or a fifth) and the rest they fund in lieu of fees. So far so good. The investor has to put in very little and yet he makes a good return. But, the catch is in a very basic fact that this is a bet on rupee. More investors are likely to have stake in rupee's movements as a result of it. In the event of any unfavourable development on India's fiscal front, there will be more pressure and rupee can nosedive significantly.
