Reply #21: The $50 to $60 trillion is the "notional" value. [View All]

A derivative is a financial instrument that derives its value from another asset. The notional value is the price of the underlying asset times the number of units of that asset. There are always two parties to a derivative and most derivatives are a zero sum game so the notional values of a derivative usually zero out.

For example, say you buy an option from your broker to purchase 100 shares of XYZ stock at the current price of $10 per share. Your option derives its value from the price of the stock and therefore is a derivative with a notional value of $1,000. Your broker's obligation to sell you the stock if you exercise your option also is a derivative which has a notional value of $1,000. So the total notional value of these derivatives is $2,000. But there is not $2,000 of risk or money involved. If the stock goes to $11 and you exercise your option you will have a gain of $100 and your broker may or may not have a loss depending on the price he paid to acquire the stock. However, the broker will have a paper loss of $100, which zeroes out your gain.

The most common form of a derivative is a home owners insurance policy. A home owners insurance policy derives its value from the value of the home (usually either the purchase price or the replacement value.)