How derivatives work

Perhaps nothing symbolises the sophistication of modern finance like derivatives - the power tools for people who wear pinstripes.

They are the family name for investments that are based on, or derived from, more traditional investments, like stocks or currencies. So, instead of buying a stock, sophisticated investors can buy, say, an option, which allows them to buy or sell that stock at a set price on a specific day in the future.

Investors use derivatives to protect against risks, such as sudden changes in stock prices or currency values. Others tap derivatives to take on extra risk, in the hope of extra gains.

Sometimes, though, derivatives go haywire. That's what happened this summer with an entire class of mortgage-based derivatives. Investors had bought them to earn attractive monthly income. But it turned out, when defaults by subprime borrowers began to soar, that these mortgage-backed securities carried lots of risk. Their value plunged.

And the complexity of the newest ones, called collateralised debt obligations (CDOs), makes it hard to know the risk that still remains. So few buyers are showing up.

"It's called financial engineering for a reason," says Joseph Mason, an economist at Drexel University in Philadelphia.

"Engineering with space-age materials leads to great performance when it performs well." But a rocket ship can also explode, he adds.

In this case, it didn't help that credit-rating firms gave many CDO products top grades. Each CDO spawns a range of bond-like products defined by "tranches" - segments that carry varying risk and return potential.

"Even within a single CDO there are two tranches of AAA-rated securities with very different risk profiles," writes Joshua Rosner of the investment research firm Graham Fisher & Co. And neither is as secure as government bonds with the same rating, he adds.

These problems don't mean that derivatives are, on balance, bad for the economy. Most economists say they allow an investor to fine-tune his financial risk - and they make markets more efficient. In mortgages, the rise of derivatives since 1980 helped to make credit more available to first-time home buyers, researchers say.