Hi money people..... I was watching Bloomberg this morning and a guest(some former fed chair) said the next problem in the market will be the derivatives.  Frankly I know nothing about them and would appreciate some imput from someone who could.  I would like to know how to avoid them while still possible investing in an international bond fund.  Appreciate your two cents.

Mrs. S 

There's a world of information on the internet about derivatives, but in general, I'd summarize that a derivative owns an event rather than an asset.  So, options are the right to sell or the right to buy a stock by the event date at an event price.  Futures are a pre-arranged sale of a stock or a commodity.  Then there are ones that are essentially insurance policies.  Your homeowner's insurance is in this sense a derivative: you pay for it but it's worthless to you until there's an event (fire, hurricane, burglary, trip-and-fall lawsuit) that cause it to have a cash value that will be paid to you.  In this vein, there are derivatives where one party will pay to the other party based on some agreed event: an index price goes down by a certain amount, a measure of volatility meets a target, a company doesn't pay it's bills on time...

Two parties can construct a contract where one will pay the other in the event a third company doesn't pay it's bonds.  These are "Credit Default Swaps" (CDS) and are much more in focus in the news today because many were written against the new "AAA"-rated mortgage bundles.  The AAA rating meant the insurance premium was low, and with perfect hindsight, entirely too low for the risk of default in the mortgage pool.  In some cases, there is more money contingent in the insurance against a default event rather than in the underlying bucket of subprime mortgages.  It is possible that if the mortgage bucket or a series of mortgage buckets fails to pay, there may not be enough money at the CDS sellers to pay the CDS buyers.  The uncertainty in derivatives is just how much of this will there be. 

 As to your mutual funds, regulation prevents most mutual funds from having more than 10% or so of assets in derivatives.  Many mutual funds, as a matter of policy, do not invest in any derivatives at all.  Newer categories of funds, which might be named "market neutral", "long-short" or "130 / 30" funds, attempt to use short positions and derivatives to reduce risk or achieve specific goals.

In any event, the fund's prospectus must spell out the fund's derivatives policy as a part of the overall investment policy.  Request it, read it, and if they state the manager is allowed to use up to x% of capital on options, swaps, futures, shorts, margin positions, or contracts for any reason that is fishy or not clear to you, just avoid that fund. 

Thanks Phillygoat.... I will be interesting to see how the derivative problem if it is a problem plays out.