“I have always liked Warren Buffett’s succinct definition of derivatives — “financial weapons of mass destruction” — but, just to be clear, derivatives are called that because their price is derived from underlying assets such as stocks, bonds, commodities, or just about anything else. They can also be derived from entities that have no intrinsic value at all, including things like interest rates or an index. There are more types of derivative transactions than any one human being could imagine—swaps, caps, collars, forwards, etc. Plus combinations of any or all of them. Got it?
“Fortunately, we can discuss derivatives without knowing exactly how they work, just as we can talk about hydrogen bombs without understanding the physics of fusion or fission. Not to belabor the analogy, but when either goes off, the results are guaranteed to be spectacular.
“It was speculation in derivatives based on residential mortgages–Mortgage-Backed Securities and Credit Default Obligations– that brought down Bear Stearns, Lehman Brothers, crippled AIG and required American taxpayers to bail out the banks that were deemed too big to fail.”
Read Ted Kaufman’s full Forbes op ed here