What is derivatives in fund management?

http://www.difm.uk.com/Foryou.asp, fund management seem straight foward enough, but does anyone know what that term means?

A derivative is a synthetic security based upon another real security. For example, a stock warrant is the ability to buy a stock at a specific price for a specific period of time. The synthetic is the warrant because it is just a promise to pay, while the stock is a real thing - a partial ownership of a real company.

Now that is just one example of a derivative. They typically enable someone to a directional bet of something else - a stock price, a bond price, a commodity price. However, they can become quite complicated as you can engineer them to be very specific. For example, you can "straddle" the market for a specific period of time, which is a derivative overlay that short the market lower than the current price and goes long at a higher price than today, so the effect is having insurance whereby losses below a certain level are offset by gains on the short (but is countered by selling the upside above a certain level). Investors can slice and dice various securities in many, many, many different ways - by time, by bond payment, by default priority, by price, by many other factors that make the market very useful to hedge against losses and very effective (or dangerous in the wrong hands) at making big bets. This is particularly true since derivatives are naturally "leveraged" instruments, which means they usually have very high volatility compared to the underlying asset. This means a small investment can turn into a huge return (or huge losses).

Currently, there are about 250 trillion dollars in nominal value of derivatives written every quarter. Think about that. That's a lot of money.




FYI: the link is broken