What Is the Hedge Ratio?
The hedge ratio compares the value of a position protected through the use of a hedge with the size of the entire position itself. A hedge ratio may also be a comparison of the value of futures contracts purchased or sold to the value of the cash commodity being hedged.
Futures contracts are essentially investment vehicles that let the investor lock in a price for a physical asset at some point in the future.
The hedge ratio is the hedged position divided by the total position.
How the Hedge Ratio Works
Imagine you are holding $10,000 in foreign equity, which exposes you to currency risk. You could enter into a hedge to protect against losses in this position, which can be constructed through a variety of positions to take an offsetting position to the foreign equity investment.
If you hedge $5,000 worth of the equity with a currency position, your hedge ratio is 0.5 ($5,000 / $10,000). This means that 50% of your foreign equity investment is sheltered from currency risk.
Types of Hedge Ratio
The minimum variance hedge ratio is important when cross-hedging, which aims to minimize the variance of the position's value. The minimum variance hedge ratio, or optimal hedge ratio, is an important factor in determining the optimal number of futures contracts to purchase to hedge a position.
It is calculated as the product of the correlation coefficient between the changes in the spot and futures prices and the ratio of the standard deviation of the changes in the spot price to the standard deviation of the futures price. After calculating the optimal hedge ratio, the optimal number of contracts needed to hedge a position is calculated by dividing the product of the optimal hedge ratio and the units of the position being hedged by the size of one futures contract.
Key Takeaways
- The hedge ratio compares the amount of a position that is hedged to the entire position.
- The minimum variance hedge ratio helps determine the optimal number of options contracts needed to hedge a position.
- The minimum variance hedge ratio is important in cross-hedging, which aims to minimize the variance of a position's value.
Example of the Hedge Ratio
Assume that an airline company fears that the price of jet fuel will rise after the crude oil market has been trading at depressed levels. The airline company expects to purchase 15 million gallons of jet fuel over the next year, and wishes to hedge its purchase price. Assume that the correlation between crude oil futures and the spot price of jet fuel is 0.95, which is a high degree of correlation.
Further assume the standard deviation of crude oil futures and spot jet fuel price is 6% and 3%, respectively. Therefore, the minimum variance hedge ratio is 0.475, or (0.95 * (3% / 6%)). The NYMEX Western Texas Intermediate (WTI) crude oil futures contract has a contract size of 1,000 barrels or 42,000 gallons. The optimal number of contracts is calculated to be 170 contracts, or (0.475 * 15 million) / 42,000. Therefore, the airline company would purchase 170 NYMEX WTI crude oil futures contracts.
FAQs
The hedge ratio compares the value of a position protected through the use of a hedge with the size of the entire position itself. A hedge ratio may also be a comparison of the value of futures contracts purchased or sold to the value of the cash commodity being hedged.
How is a hedge ratio calculated? ›
The Hedge Ratio is calculated by dividing the total value of the portfolio by the total value of the hedged positions. To calculate the Hedge Ratio, you divide the change in the value of the futures contract (Hf) by the change in the cash value of the asset that you're hedging (Hs). So, the formula is: HR = Hf / Hs.
What is the formula for the minimum hedge ratio? ›
The minimum variance hedge ratio equals the product of the correlation coefficient spot price change, futures price change and standard deviation spot price change divided by standard deviation futures price change.
What is the formula for hedge effectiveness? ›
The hedge effectiveness equals the standard deviation futures price change squared times the minimum variance hedge ratio squared divided by the standard deviation spot price change squared.
What is the formula for hedge options? ›
h = ∂C/∂S, this is called the delta of the call option. Thus the proper hedge ratio for the portfolio is the delta of the option.
How do you calculate hedges? ›
Hedges's g is named for Gene V. Glass, one of the pioneers of meta- analysis. g = t√(n1 + n2) / √(n1n2) or g = 2t / √N Hedges's g can be computed from the value of the t test of the differences between the two groups (Rosenthal and Rosnow, 1991). The formula with separate n's should be used when the n's are not equal.
What is the formula for hedge ratio in CFA? ›
Hedge ratio n = (p- - p+) / (S+ - S-). A risk-free hedge has the same positions in the two instruments (underlying and the put).
What does a hedge ratio of 0.5 mean? ›
If you hedge $5,000 worth of the equity with a currency position, your hedge ratio is 0.5 ($5,000 / $10,000). This means that 50% of your foreign equity investment is sheltered from currency risk.
What is the delta hedge ratio formula? ›
The delta (hedge ratio) of a derivative f is defined as ∆ ≡ ∂f/∂S. Thus ∆f ≈ ∆ × ∆S for relatively small changes in the stock price, ∆S. A delta-neutral portfolio is hedged in the sense that it is immunized against small changes in the stock price.
What does a hedge ratio of .70 implies? ›
Answer and Explanation:
A hedge ratio of 0.70 implies shorting 0.70 calls for every long position in the stock. This means that 70% of the portfolio is hedged and is protected against short-term movement. A hedge ratio is used to hedge long positions or forward positions in any instrument.
The benchmark hedge ratio is a financial risk management concept used to determine the optimal proportion of an investment portfolio to hedge against market risks.
What is the hedge effectiveness ratio? ›
An optimal hedge ratio is typically calculated by regressing historical spot prices, spot price changes or spot returns on futures prices, futures price changes or returns. The slope of the regression is then used as the optimal hedge ratio.
What is the perfect hedge model? ›
A perfect hedge is a position that eliminates the risk of an existing position or one that eliminates all market risk from a portfolio. Rarely achieved, a perfect hedge position has a 100% inverse correlation to the initial position where the profit and loss from the underlying asset and the hedge position are equal.
What is the minimum hedge ratio? ›
The minimum variance hedge ratio, also known as the optimal hedge ratio, is a formula to evaluate the correlation between the variance in the value of an asset or liability and that of the hedging instrument that is meant to protect it.
How do you calculate hedging margin? ›
How do I calculate the margin required on hedged positions?
- Pav: the volume-weighted average price.
- Open Price 1: the price at which the first position is opened.
- Open Price 2: the price at which the second position is opened.
- Open Price X: the price at which Position X is opened.
The closer ρ is to one, and the larger is the variance of the product you are hedging, the more you hedge. The larger is the variance of the product used to hedge the lower the hedge ratio. It is even possible that h would be greater than 1.
What is the formula for hedging bets? ›
Bettors can use this equation to ensure they break even: hedge bet stake = Original bet stake/(hedge bet decimal odds-1).
What is 1 1 hedge ratio? ›
Hedge ratio refers to the number of units that are used as hedging instrument for the purpose of hedging a hedged item. Usually, the ratio is 1:1 for most of the financial instruments.
