Risk is a concept that denotes a potential negative impact to an asset that may arise from a future event. In everyday usage, “risk” is often used synonymously with the probability of a lost. All human activities involve some sort of risk.

Some risks can be calculated and, to some extent, a value at risk can be assessed. As risks can sometimes be measured, it is possible to reduce those risks, in different manners. For example, insurance is a risk-reducing investment in which the buyer pays a small fixed amount to be protected from a potential large loss.

Many definitions of risk depend on the specific situation. Generally, risk is related to the expected losses which can be caused by a risky event and to the probability of this event. Risk and opportunity go hand in hand.

The opportunity for profits cannot be achieved without taking risk. Risk is not bad. But we must learn to balance the possible negative consequences of risk against the potential profits of its associated opportunity.

Using Derivatives To Hedge Risk

Hedging simply means protecting against potential losses.
Depending on the risk, it is possible to hedge risks by using derivatives contracts.

In cases where an opportunity has a risk level that is too high, derivatives can be used to reduce, or hedge, the risk to an acceptable level.

Hedging risks with derivatives – In simplest terms, derivatives are used to transfer risk from one party to another. The party that is reducing its risk is called a hedger.

The party that is accepting the risk is called a speculator. Generally speaking, hedging involves recognizing and measuring the financial risk of an existing position, then taking on some new position with opposite exposure characteristics such that the gains and losses of the positions cancel each other out.

In essence, you no longer care if the original position loses money because the hedge position will make money to compensate. And if the hedge position loses money, no problem, the original position makes money to compensate.

Derivatives are a natural financial risk management tool because a derivative’s value is determined mainly by the value of its underlier. Offsetting positions in a derivative and its underlier tend to neutralize changes in the underlier’s value.