Financial contracts whose value is derived from underlying assets, often used for speculation
A derivative is a financial contract whose value is derived from the performance of an underlying asset, index, or interest rate. Common derivatives include options, futures, swaps, and collateralized debt obligations (CDOs). While derivatives serve legitimate hedging purposes, they have also been used as instruments of speculation and financial engineering that obscure risk and enable systemic fraud.
The derivatives market played a central role in the 2008 financial crisis. Banks packaged subprime mortgages into mortgage-backed securities (MBS), then created CDOs from tranches of these securities, then created "synthetic CDOs" — derivatives of derivatives — that multiplied the exposure to the underlying bad loans. Credit default swaps (CDS) — essentially insurance policies on these instruments — were sold by firms like AIG without adequate reserves to cover potential losses. When the housing market collapsed, the derivatives web amplified losses throughout the global financial system.
The notional value of the global derivatives market has been estimated at over $600 trillion — several times global GDP. Warren Buffett famously described derivatives as "financial weapons of mass destruction." The opacity and complexity of derivative instruments make them ideal vehicles for concealing risk from investors, regulators, and the public.
