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What are derivatives anyway, and why are people saying such terrible things about them?

Some critics see the derivatives market as a multitrillion-dollar house of cards composed of interlocking, highly leveraged transactions. They fear that the default of a single large player could stun the world financial system.

But others, including Federal Reserve Chairman Alan Greenspan, say the risk of such a meltdown is negligible. Proponents stress that the market's hazards are more than outweighed by the benefits derivatives provide in helping banks, corporations, and investors manage their risks.

Because the science of derivatives is relatively new, there's no easy way to gauge the ultimate impact these instruments will have. There are now more than 1,200 different kinds of derivatives on the market, most of which require a computer program to figure out. Surveying this complex subject, dozens of derivatives experts offered these insights:

Q: What is the broadest definition of derivatives?

A: Derivatives are financial arrangements between two parties whose payments are based on, or "derived" from, the performance of some agreed-upon benchmark. Derivatives can be issued based on currencies, commodities, government or corporate debt, home mortgages, stocks, interest rates, or any combination of these.

Company stock options, for instance, allow employees and executives to profit from changes in a company's stock price without actually owning shares. Without knowing it, homeowners frequently use a type of privately traded "forward" contract when they apply for a mortgage and lock in a borrowing rate for their house closing, typically for as many as 60 days in the future.

Q: What are the most common forms of derivatives?

A: Derivatives come in two basic categories— option-type contracts and forward-type contracts. These may be exchange-listed, such as futures and stock options, or they may be privately traded.

Options give buyers the right, but not the obligation, to buy or sell an asset at a preset price over a specific period. The option's price is usually a small percentage of the underlying asset's value.

Forward-type contracts, which include forwards, futures, and swaps, commit the buyer and the seller to

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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