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Getting clarity on the murky world of derivatives

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By Neil Irwin
Washington Post Staff Writer
Saturday, April 17, 2010

The debate about overhauling financial regulation is focusing on the vast and murky world of financial derivatives. Here are some key things to know:

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What the heck is a derivative?

It's a contract between two parties in which money changes hands based on some other market condition, such as future interest rates or stock prices or value of a currency. They are called derivatives because their value is derived from something else. They grease the wheels of global capitalism -- a farmer can lock in the price of corn before he plants, or a company that does business abroad can protect itself from currency fluctuations.

What are the different types of derivatives?

Many derivatives are traded on market exchanges, which functioned with few problems through the financial crisis. Things get more complicated with "over-the-counter" derivatives, which are traded through private intermediaries, often including a Wall Street firm. These include "credit-default swaps," which allow an investor to buy protection against losses if a bond goes bad.

How big are these markets?

Enormous. Over-the-counter derivatives worldwide were worth about $25 trillion in 2009, about half the value of the world's stock markets, the Bank for International Settlements estimates. The "notional value" of these derivatives is astronomical, totaling $604 trillion, or about 10 times the annual economic output of planet Earth. Think of the difference between the two numbers this way: The price of an insurance policy on a $200,000 house might be only $1,000. But the notional value, should the house burn down, is the full $200,000.

Why are over-the-counter derivatives dangerous?

They were a significant contributor to the financial panic that swept the world in 2008, in part because of a lack of transparency. A firm that bought a credit-default swap to protect itself against losses on bonds was only as safe as the company it bought the swap from. To go back to the home insurance analogy, if your house burns down and the insurance company turns out to be Lehman Brothers, which went under, you're left with a huge loss even though you thought you were covered. Part of the reason the crisis was so bad was that no one knew exactly which firms were exposed to risk from which other firms and for how much money.


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