my understanding of derivatives

I posted this as well on Winterwatch. I think it illustrates how I think about derivateves.

I recently read Satyajit Das’s book “Traders, Guns, and Mony”. Das is perhaps the world’s foremost expert on derivatives. If I remember correctly, Das says that the typical CDO has the following structure: 1-2% equity tranch (usually held by the issuer), 3-4% mezzanine (all risk with no gain), 95% investment grade.
Incidentally, this is exactly the way the Titannic was built. The ship had 10 bulkheads, to prevent a leak in one from filling up the whole boat. However, the bulkheads only went 90% of the way up to the ceiling. After the first one filled, the water just flowed over into the next. The equity tranches have been sunk by losses, the mezzanine are almost full, and the investment grades are next. See www.Markit.com for their ABX indices. Prices range from 95 for AAA to BBB in the 30’s.