Importance of Derivatives

DERIVATIVES During the crisis, derivatives were heavily used in the entire financial system which may seem to mitigate the effects by transferring risks from one party to another. The video “Crisis of Credit Visualized” helped me understand how the financial system worked as a whole connected from home owners, to brokers, to lenders, to bankers, to investors and many other financial institutions. Apparently, most of the people do not understand how derivatives work since it’s quite complicated. Derivative instruments used during the crisis were Credit Default Swap and Collateralized Debt Obligation. Credit Default Swap is considered an insurance against non-payment which generally plays as a means for transferring risk from one party to another. Collateralized Debt Obligation represents different types of debt and credit risk. These different types of debt are referred to as slices, where each slice has a different maturity and risk associated with it. The higher the risk, the more the Collateralized Debt Obligation pays. At first, everything was going smoothly within the financial system and everybody’s getting more and more money through derivatives. As the video illustrated how it works, owning a house was a dream come true for a lot of people through mortgages. Then the Investment Bankers borrow money to buy the mortgages from the lender and so the payments of the home owners are directed to the Investment Bankers. The Investment Banker now has pooled it which is the Collateralized Debt Obligation. The Investment Banker then sells it to different investors for the different slices- the safe, okay, and risky. The safe slice refers to the Credit Default Swap where the buyer speculates that the possibility on the possibility that the third party will indeed default. Everything was great, Investors wanted more! They forgot that the initial intention was to defend against risk and protect against the downside. However, derivatives became speculative