How do debt derivatives work? How do they tie into debt/speculative bubbles that pop?
In: Economics
This is truly not an ELI5. But derivatives basically a of package other investment and assets and rather than selling the “original” asset, it sells a portion of the risk of the underlying assets. Investments or assets have different risks broken down into areas like currency, interest, liquidity, default etc. Analysts using lots of models and maths try to evaluate these risks separately and create special contracts that offload specific risks. These contracts are what are deemed derivatives – ie the risk and therefore their value is derived from some underlying asset.
The problem with these models is that they can be very very complex and few people, even the top investment banks, understand them well. Because these contracts are large, leveraged and priced off these models, a slight change in situations (or a misunderstood risk correlation) results in huge value changes.
Used properly to offload risk, it makes sense to enter into derivative contracts. But if neither the buyer nor the seller understands the risk models, they may incorrectly believe they have offloaded some risk and this allows them to take on more risk in other areas.
The whole thing unwinds when something goes wrong and there are unexpected losses, causing the investors to rapidly try to dispose these derivatives which pushes the prices down further and this becomes a price freefall. This is why they call it a “bubble” – it inflates but when things go bad, it suddenly becomes an asset that no one will purchase at literally any price, ie it “pops”.
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