Financial assets and risks are closely related. Every asset carries a value and a risk. The value of an asset is the price the owner can get by selling it. In liquid markets, e.g. for shares of big corporations, government bonds or commodities, where many standardized units are traded, the price of an asset is clearly defined at any time.
For other asset classes, like real estate or shares of small companies the only way to determine the real value of an asset is to sell. In such cases models and recent prices of similar assets are used to determine the asset value. The resulting valuations are more or less educated guesses.
For this discussion of the relationship between financial assets and risks I want to stick with liquid assets with a known market price.

The Risk
After defining the value of an asset, the next question is: What is the meaning of the term “risk” in the context of financial assets? Modern trading platforms allow us to know the current price of any liquid asset with precision. But do we know tomorrow’s price of the same asset? We do not know. The price can change, most probably will change. But we do not know in which direction. This insecurity about the future price of an asset is called the asset’s financial risk. Risk is a complicated concept having at least three dimensions:

1. The magnitude of the price change
2. The probability that this change will actually happen
3. The timing

Risks have also a value and price. But the price of a risk can be negative. In our day-to-day thinking, we associate the term “risk” with an undesired possibility. If we would profit from the same possible event, we would use the term “hope” instead of “risk.” This distinction between “hope” and “risk” relates solely to our position relating to the possible event. It is possible and in the financial world standard, that one party’s “risk” is for the counterpart “hope”. A high price for wheat may be the farmer’s hope, but the baker’s risk.
For this discussion, we use the term risk for the probability and magnitude of a possible change regardless of the question whether we desire or fear that specific outcome. We do not differentiate between “hope” and “risk”.

Trading Risk
As the same event can be good for one person and at the same time very bad for another person, it makes sense to trade risks. Both could share the pain and the gain and improve their ability to plan their businesses.
Financial institutions developed tools to separate financial assets and risks form one another. One very simple example would be a contract between the farmer and the bakery spelling out that the bakery will buy a certain quantity of wheat in autumn from the farmer for a specified price. This price could be a little higher than the current price, thus giving the farmer an extra profit. But it would protect the bakery from the danger of a huge price rise making the bread too expensive for the bakery`s customers. This generic future contract would be a good deal for both sides.

Futures and Options
The contracts used to separate financial assets and risks are called derivate contracts. The example between the farmer and the bakery is a future contract, in which they agree to a sale of a certain quantity of a certain asset for a predetermined price at a specified time in the future. This future contract is binding for both sides, the farmer must sell and the bakery must buy.
Another generic form of a derivate contract is an option. The option comes in two forms:

The Call
The farmer could sell a call to the bakery. In this case the bakery would pay the farmer for the right to buy a certain quantity of wheat in autumn for a specified price, the “strike price”.
This contract is legally binding for the seller of the option, the farmer. The buyer of the option, the bakery, exercises its right if he chooses. Otherwise the contract will expire.

The Put
The bakery could sell a put option to the farmer. In this case the farmer would pay the bakery for the right to sell a certain quantity of wheat in autumn for a specified price, the “strike price”.
This contract is legally binding for the seller of the option, the bakery. The buyer of the option, the farmer, exercises its right if he chooses. Otherwise the contract will expire. Please note, that in this case the buyer of the option is the seller of the underlying asset.

Hedges
If you combine two risks, the sum of the two original risks may be bigger than the combined risk. Think about an area with frequent hurricanes: It could make sense to bet on a profit of insurance companies and to bet at the same time on a profit of building companies. In a strong hurricane season, the insurance would suffer and the builder would profit. In a weak hurricane season, the insurance company would profit and the builder would lose. If you buy insurance company shares and shares of the home builder, you can smooth out the difference between years with strong hurricanes and years with weak hurricanes. If you use options or futures on the shares of both companies, you may even be able to profit financially from the hurricane threat.

Warning
Be careful. Derivate contracts are very powerful tools with a high leverage. Because they allow you to treat financial assets and risks separately, you can also accumulate dangerous risks, if you mishandle them. The result can be very and painful and dangerous. Never enter a contract, if you do not understand all implications completely.

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