[Leaning Right]

Here is what I understand about derivatives. They are essentially bets on debt and only a fool would buy into them.

Not necessarily. Suppose you have $1000 invested in Microsoft stock. You want to protect that money, yet you still want to keep it in the market.

So you buy a derivative from the Leaning Right Investment Corp. The derivative costs you $10. In return, I promise to pay you $500 if Microsoft drops by more than 20 points in the next year.

I am offering you a type of insurance, a "derivative". Its value is derived from the value of something else, in this case the value of Microsoft stock.

If you are a conservative investor, you might want to buy that derivative from me. But onl;y if you trust that I can actually pay you if Microsoft stock declines.

There are, of course, some derivatives that are insanely risky. But some do make sense.

[RetiredTexasVet]

It’s only “insurance” if you have an insurable interest. With a derivative, I buy $10 “insurance” against MS stock dropping but I don’t own any MS stock and you promise to pay me $500 if it drops 20 points.

This is why derivatives were outlawed after the 1929 stock market crash (you had to have an insurable interest) but the Wall Street gamblers brought them back in the 1990s.

[Revel]

Right.

And the real problem is that given a certain event the banks selling the insurance couldn’t begin to pay off more than a small fraction of what they supposedly insured.