Wall Street has a very nuanced understanding of risk. Before I headed west to work in high tech, I thought I might go into finance, even working at Goldman Sachs (albeit in technology) in 2008. Even though I don't work in banking, the way Wall Street packages and transfers risk continues to fascinate me.

It's a big topic, but I'll try to summarize a few keys ideas here.

Key idea 1: Securities are packages of risk

Wall Street views any investment position or security as a bundle of several risks. And with a few exceptions [1], those risks are taken to be like the weather: something you can watch, but not change.

The US government issues bonds. In general, bonds are a bet on two things: whether the issuer will make its payments (credit risk), and whether interest rates will go up or down (interest rate risk). Buying treasury bonds is basically a pure bet on interest rates, because most people think the government would print money to repay before missing a payment. But interest rates matter a lot on long-term debt; if you buy a bond paying 4% and rates go up to 8%, you're stuck with below-market return for a long time. That's why, contrary to popular belief, long-term debt—government bonds, mortgages, pensions—actually entail a lot of risk.

Corporate debt (debt issued by a private company) is like US government debt, but the issuer can't print money, so they might miss a payment—credit risk. So corporate debt, or "corporates" as they're called = firm-specific credit risk + interest rate risk.

Stocks are a combination of overall economic growth (all companies will do poorly in a bad economy), and company-specific factors like product adoption, brand strength, and management capability. Decomposing stocks gets messy, because so much rests on the company itself; but actually less than most people think, as stocks are driven by broad market trends more than most people realize.

The point is that every position can be decomposed into a bunch of component risks [2].

Key idea 2: Each risk has a price

When a market exists in two almost-identical products, for instance a treasury bond and a similar bond that's inflation-indexed, they will differ in price. The difference is the market's opinion of what's fair for taking that risk.

Example: if a 30-year treasury bond pays 2% and a similar 30-year corporate pays 3.5%, that means the market is pricing the additional credit risk of the corporate at 1.50%, or "150 basis points" or "bips", as they say on Wall Street. That's a pretty narrow "spread", meaning the market has high confidence in the issuer's ability to repay.

These "spreads" convey a ton of information, things like whether the market thinks debt is likely to be repaid, the odds of interest rate hikes, all sorts of stuff. It's there in the open, for all to see; you just have to know where to look.

Some risks are worth it, others aren't. A lot of money is made and lost when mispriced risks are identified; too cheap, if there's a lot more risk than is widely acknowledged, or too expensive, if something is more of a sure thing than it looks.

Key idea 3: Hedging

Hedging is "canceling out" a risk.

If an investment position has some risks you like and others you don't, hedging allows precise control of which risks you'd like to take.

Hedging is perhaps the main reason the futures and options markets exist. Farmers who produce a huge grain crop have a huge (risky) exposure to grain prices; the futures markets let them transfer some of that risk to someone else.

Sophisticated market participants understand how to "manufacture" hedges that can be bought and sold from the "raw materials": options out of cash, debt, and shares, as in delta hedging. This "risk alchemy"—taking things apart, putting them back together, and making money on it—is a lot of what goes on in sophisticated trading houses.

Cost of debt comes up a lot in hedging. Banks can usually create hedges more cheaply than retail investors because they can borrow more money at lower interest rates.

Don't be a trader

I keep hearing these ads about how much money you can make trading futures and options.

If your idea of a good time is competing with the smartest people on Wall Street, with their computers and models, by all means, go ahead…that's not a risk I'd take, though.

("That's not a risk I would take". There I go, using the ideas from this article, without even thinking about it; this stuff is lodged pretty deeply in my brain.)

[1] Corporate turnaround specialists ("raiders") make it their job to buy companies and change or "fix" them; most investors, and especially traders, don't get involved in what they own, preferring to buy and sell from a distance.

[2] It's basically PCA