Options

• Many investors are familiar with puts and calls that are traded on the Chicago Board Options Exchange. Puts are contracts to sell specified stock shares at a certain price and calls are contracts to buy at a certain price. Most people don't think of these as derivatives, but they are because they are securities based on contractual agreements to perform certain activities with respect to a specified issue of common stock. They are derived from the combination of common stock and a contract to perform.
  
  

Credit Default Swaps

• Credit default swaps, known as CDs, were one of the prime areas of concern during the credit crisis of 2008. They were originally intended to protect bond buyers from losing all their investment if the company that issued the bond went bankrupt and could not pay interest and principal. They are derivatives that consist of Treasury futures or options combined with contracts that obligate the CDs issuer to pay the interest and principal in the event the bond issuer goes bankrupt. It is an unregulated insurance policy.
  
  

Interest Rate Swaps

• Like a CDs, an interest rate swap is an unregulated form of insurance. It allows a bank, that must borrow money to finance loans, made during a period of low interest rates, to protect itself in the event interest rates rise and its borrowing costs exceed the interest it is receiving on its loans. The other side of an interest rate swap is normally a corporation that for tax or other reasons finds it beneficial to pay the higher interest rates to the bank for its depositors in return for the bank paying a fixed rate on the corporation's long-term bonds. It may not sound like a good deal to the uninitiated, but it can result in significant tax savings for the corporation while allowing the bank to cut the cost of its borrowings to a level where it at least breaks even on its loan revenues. Treasury bonds or bond futures are generally used to guarantee the performance on either side or to supplement interest payments.
  
  

Trouble

• During a financial crisis, derivatives sometimes don't work. This is because they employ hedges using bond futures and options on futures. When everyone is hedging, hedges tend not to perform as expected because everyone heads for the door at the same time. Hedges are based on normal trading experience and, if something is causing a flight to quality, regular interest rates on bank CDs may rise while Treasury rates drop as everyone buys Treasuries for the safety they provide. Another problem with derivatives came to light in 2008 as the CDs contracts turned out to not be supported by enough bond value. Because the derivative market is unregulated, it was possible for firms writing CDs contracts to under-fund the contracts, making them worthless when they were redeemed. For example, when American International Group (AIG) was about to file bankruptcy in 2008, it was discovered that the CDs covering investments in AIG were under-funded by Lehman Brothers, forcing the U.S. Government to pay off the contracts because Lehman was insolvent.