Making sense of derivatives

Over the counter derivatives market, one of the biggest contributors to the ongoing financial crisis, had an estimated size of about $596 trillion by end of 2007. In contrast, the value of the world's financial assets—including all stock, bonds, and bank deposits—was pegged at $167 trillion.

But the numbers may be deceptively high as there are often multiple derivative contracts on the same underlying asset, not all contracts involve actual delivery of the asset or culminates in a transaction, and since many contracts hedge risks they essentially cancel one another out. So a more meaningful way of measuring the size of the derivatives market is to calculate the instruments' market value — which refers to how much they would be worth if the contracts had to be settled today. Gross market value of all outstanding derivatives was $14.5 trillion at the end of 2007, less than one-fortieth of the $596 trillion estimate. That number shrinks to about $3.3 trillion once you take into account contracts that directly offset one another.

Update 1
Gretchen Morgenson has this account of how the complex derivatives borught about the downfall of the likes of Merrill Lynch.

Update 2 (7/3/2010)
Gretchen Morgenson on swap contracts entered into by Greece and municipal bodies in the US that hugely benefitted the advisors and banks that arranged those deals.