A derivative security is a security that “derives” from some other security.
To take an easy example a stock option is an option to buy (or sell) a particular stock at a particular price at a particular time. I would say that a stock option is a “derivative” as it derives from the stock which is another security.
In and of itself - derivatives are not intrinsically evil.
But as a practical matter, derivatives are often leveraged up the ying-yang. So for an intial investment of a few dollars you can potentially make (or lose) many times that. That’s where the real danger comes in.
Also as the derivatives themselves become more obscure in nature, they become more and more difficult to figure out what the heck they are actually worth at any given time. That creates all sorts of problems because a bank can say, hey we think they’re worth X so that’s how we’re valuing them on our books. And they have every incentive to paint a sunny day scenario.
Not to mention that "they" also have every incentive to structure derivatives to be as obscure and complicated as possible, since that makes it a whole lot easier to assign wildly inflated valuations to them, without anyone being able to specifically show why the valuation is wrong. It's not hard to value stock options or interest rate swaps on a day-to-day basis. And that's why those aren't the sort of derivatives that are causing the problems.
carolyn
excellent post!