Question

Identify and define a derivative that played a role in the crisis, mortgage backed securities, credit default swaps, then explain why the abuse of these derivatives caused problems.

Answer 1

The real cause of the 2008 financial crisis was the growth in the number of unregulated derivatives. They derive their value with reference to some underlying asset and an example of such a derivative is Mortgage backed Security.

When the fed started rising the fed fund rate, the interest rates on these securities rise along with the Fed funds rate.Te mortgage holders could no longer afford the payment.Rise in the interest rates led to fall in the demand for housing and these mortgage holders could not repay the loan back and they defaulted on the loan.

Some other types of derivatives are Collateralized debt Obligations, Credit Default Swap.

The main problem with these derivatives is that the market is extremely complicated and difficult to value.The market is also regulated by Securities and Exchange Commission. Thus, there is lack of trust among the market participants.