..{as I was saying}; With your hard-earned money. -- Inexplicably, {or perhaps not}; The politically 'lobby' financed, 'US' congress; Recently applied a virtual band-aid, to this {also virtual} 'gaping wound.'
- In any event; Until, good ol' Common Sense; Once again re-asserts itself; The following link, at least allows us {mainly 'US' citizens}, to 'chuckle'/'cry, over our beer.' {continued, beneath one of the 'better' cartoons}

Ps.- {Cursor} 'click' on any cartoon{s} you so choose, {may involve up to 2 consecutive 'clicks'}; For a Bigger enlargement.
http://www.google.com/images?hl=en&source=imghp&biw=1024&bih=525&q=derivatives+cartoon&btnG=Search+Images&gbv=2&aq=f&aqi=&aql=&oq=&gs_rfai=

here's a list of derivatives that are well known and well used. They are used for hedging against interest-rate, credit, currency, equity volatilty exposure, etc, etc. I'll list the really probematic ones though too. those would be the structured derivatives. OTC means over-the-counter, L will mean listed. the real problem is with leverage, selling short, speculation instead of hedging, ratings of tranches of structured derivatives that had no business being rated so well, things like that.
 
1. CDS index and CDS single-name deals (L,OTC)
A CDS index is a set of companies you buy/sell protection on as a group. As companies default, they get booted from the index and the spreads and notional weighting adjusted. Very popular. A single name CDS is where you buy protection for a premium spread against notional protection on a loan or bond. eg. 25 MM notional protection over 5 years, you pay either 100bps or 500 bps (IG or NIG) x notional per year + some upfront fee to account for the real spread. Selling protection is exactly the same cash-flow-wise as buying a bond.
2. CDO and synthetic CDO deals. (problems) (OTC)
A CDO is a basket of debt that's packaged into tranches and cash-flows sold to investors, in defaulting order. Higher yields are on the lowest tranches because you can have your investment wiped out first. A synthetic CDO is a package of CDS's. Recall above that the cash-flows are the same a bond, with the coupon payment equivalent to the premium insurance payments.
3. FX forwards and futures (OTC, L)
Used extensively and used to protect commodity sales, currency exposures, etc. These are completely normal.
4. equity index/single name options (OTC, L)
Used extensively. No harm no foul. Black-Scholes pricing models are often used to back out the implied volatility of current option prices to calculate 'fair-value' deals
5. equity index/single name statistical swaps (forwards) (OTC)
these are sort of rare. What they are are forward bets against a strike on the volatility, variance of an index, like the CAC, FTSE, SP500, Hang Seng, etc, or on single names. Variants are correlation, covariance, and dispersion swaps between two indices, currencies, or single-name stocks, or between an index and a subset of an index. Not a large risk at all.
6. interest-rate derivatives (OTC)
very normal. Fixed vs float bets (LIBOR + 200 bps vs fixed 4%, etc)on an initial notional. Used for hedging against interest-rate moves
7. total return swaps (can be problematic) - these are swaps where periodic payments are made one way or the other depending on if the MTM of an underlier(or basket of loans, or whatever) goes down or not. Coupon payments are made one way, A reference amount (LIBOR + x bps) made the other way, + the change in MTM....the 'x' is ~ prob-default x loss-given-default. This is the 'premium' you pay for a loan as well. Now you know....
 
There's counterparty risk during deals that span time, because if the MTM of a deal swings hugely in one party's favor, collateral better be posted by the losing counterparty from time to time to cover. ISDA master agreements govern the OTC space. If there's a bilateral CSA agreement for each deal, then collateral is posted when the market-value of a derivative deals swings too much in any counterparty's favor. The problem is actually evaluating some of these deals.
 
Unfortunately I have to know a lot about these deals where I work. I need to be able to valuate them and model them so they can be stored and reported on over the life of the deals each day. The volume of any given portfolio can be in the tens of thousands for any given institutional investor so the valuations and reporting have to be 'quick'.
 
So, I went from being interesting in particle physics to being forced to model financial instruments. The irony is not lost on the writer of these words....

 
 
..you'd think so, wouldn't you ?

There is no mystery to derivatives. it's just that they've become public attention that it's interesting all of a sudden. it's human behavior that causes problems, not financial instruments.
 
"Every failure can always be attributable to Human error" - 2001, A Space Odyssey

Dual
 
Have you read " The Big Short" by Michael Lewis? I noticed you mentioned the Black Scholes model.I worked for a trading firm for about 5 years and we priced our OTC options by Black Scholes.It really doesn't work very well in certain circumstances and Lewis's book details several of these examples and how a bunch of inexperienced kids made millions by taking advantage of it.A Great read

I'm reading it now and it's really good. A lot of the problem was due to how the tranches of CDOs of pools of ABSs were rated. I've always been a Michael Lewis fan. I read 'Liar's Poker' a few years ago and loved it.
 
We take implied volatilities of real commodity option prices, derived from a BS formula from feeds such as SuperDerivatives to fair-value our own option holdings to check the P&L on our positions. We calculate the fair-value of the call and puts by driving the Vols back through a BS formula.
 
As you mentioned, BS has some problems. The idea of BS is that the underlier price of an option as a stock/index/commodity moves around like a diffusion process over time, and with the rate of return on the underlier equal to the risk-free rate. The biggest problem I think is the assumption of constant volatility of the underlier in BS. However, I think the use of implied volatility by backing it out from current option call/put prices is extremely useful though. You can back out the volatility as a function of strike and maturity and get a revealing surface for a stock or commodity- and this surface tells you a lot about current events surrounding it (check out the option chains for BP stockfor example and where the volatility was high/low as a function of recent events...)

Lewis writes really good stuff.He did an interview last winter on 60 minutes which talked about this book which was great.I read a brief piece about Lewis where he met Gudfriend (sp) for lunch in NY recently.Gudfriend was the ceo of salomon when Lewis was there as a trainee and developing the material for liars poker.
 
I worked almost 30 years in NY for hedge funds and broker dealers and looking back on it, it was incredibly wierd at times

Don't retired yet. I'm on the way up and I could use you.

 
.. Should the above statement, be filed under the corresponding, Web Link? --
 
Ps.- Pardon, my modest unsolicited, cynicism.