Hedging

• Hedging is the practice of taking an offsetting position against an investment you are holding. In a way, it is like betting against another bet. Two common strategies for hedging using derivatives are futures and options.
  
  

Futures

• A futures contract sets the price of something in advance so that future changes in the market will not impact decisions you have made down the road. Futures are common in the agriculture industry, where the bulk of a farmer's income depends in part on the market price for the commodities he is producing. Because a farmer who is planting his crop in March cannot predict the price of that crop several months in advance, he may enter into a futures contract to guarantee a price for his crop. While the farmer may miss out on an unexpected increase in the price of his commodity, he will not have to worry about a drop in that price.
  
  

Options

• An option is a way to pay money in order to have various options in the future. The two basic types of options are puts and calls. A put option is a right to sell a particular investment while a call option is a right to buy a particular investment. For example, if you have a put option at $15 on a stock that is trading at $20, and that stock price drops to $10, you have the right to sell shares of that stock for $15, making your loss smaller than it otherwise would have been. Using options is another way to lock in a price for a security and protect yourself from a dramatic price decrease.
  
  

Risk Valuation

• When considering the risks of particular fixed income instruments, such as corporate or government bonds, institutional investors use various risk modeling tools to help evaluate the level of risk involved in that investment and determine how that should affect the price they pay. In other words, they are using models to calculate the risk premium. For a simplified example, consider a bond that is worth $1,000 and the risk of the borrower defaulting on the loan and failing to repay the lender is 10 percent. The lender would value this risk at roughly $100, or 10 percent of $1,000.