Derivatives
Financial contracts whose value is derived from the performance of an underlying asset, index, or rate.
What is Derivatives?
Derivatives are financial contracts whose value is based on ('derived from') the price or performance of an underlying asset — such as stocks, bonds, currencies, commodities, or interest rates. Common types include: options (the right but not the obligation to buy or sell at a set price), futures (an obligation to buy or sell at a future date and price), forwards (customized futures traded over the counter), and swaps (exchange of cash flows based on different reference rates). Derivatives are used for hedging (reducing risk) and speculation (taking leveraged bets on price movements). The notional value of global derivatives markets is estimated at hundreds of trillions of dollars — far exceeding world GDP. Warren Buffett famously called unregulated derivatives 'financial weapons of mass destruction.'
Example
The 2008 financial crisis was deeply entangled with derivatives: credit default swaps (CDS) on mortgage-backed securities allowed banks and AIG to write enormous amounts of insurance on risky assets without holding adequate capital. When housing prices fell, CDS payouts overwhelmed AIG and required a $182 billion government bailout to prevent a cascading financial collapse.
Source: Federal Reserve Bank of New York — AIG and the Financial Crisis