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Hedge Ratio

The ratio or comparative value of an open position’s hedge to the overall position

What is Hedge Ratio?

Hedge ratio is the ratio or comparative value of an open position’s hedge to the overall position. It is an important risk management statistic that is used to measure the extent of any potential risk that can be caused by a movement in the hedging instrument.

 

Hedge Ratio

 

Hedging is an investment practice that is popularly used as a risk mitigation technique. It involves taking a position in a financial asset or underlying to mitigate the degree of potential risk.

 

 

Summary:

  • Hedge ratio is the ratio or comparative value of an open position’s hedge to the overall position.
  • It is an important risk management statistic that is used to measure the extent of any potential risk that can be caused by a movement in the hedging instrument.
  • As the hedge ratio approaches a value closer to 1, the established position is said to be “fully hedged.” On the other hand, as the hedge ratio approaches a value closer to 0, it is said to be an “unhedged” position.

 

Hedge Ratio Formula

As the hedge ratio approaches a value closer to 1, the established position is said to be “fully hedged.” On the other hand, as the hedge ratio approaches a value closer to 0, it is said to be an “unhedged” position.

 

Hedge Ratio - Formula

 

Hedging – Strategies

 

1. Short hedges

A short hedge is when the position taken to hedge the futures or a commodity is a short position. A short hedge is normally carried out when an investor anticipates a future asset sale or when the price of the futures is expected to decrease.

 

2. Long hedges

A long hedge is when the position taken to hedge the futures or a commodity is a long position. A long hedge is normally carried out when an investor anticipates a future asset purchase or when the price of the futures is expected to increase.

 

Hedging – Types

 

1. Static hedge

A static hedge is when the hedging position or the number of hedging contracts isn’t bought and/or sold, i.e., isn’t changed, over the time period of the hedge regardless of the movement in the price of the hedging instrument.

 

2. Dynamic hedge

A dynamic hedge is when an increasing number of hedging contracts are bought and/or sold over the time period of the hedge to influence the hedge ratio and bring it towards the target hedge ratio.

 

What is the Optimal Hedge Ratio?

An optimal hedge ratio is an investment risk management ratio that determines the percentage of a hedging instrument, i.e., a hedging asset or liability that an investor should hedge. The ratio is also popularly known as the minimum variance hedge ratio. It is primarily used with the practice of cross-hedging.

Optimal Hedge Ratio

Where:

  • ρ = The correlation coefficient of the changes in the spot and futures prices
  • σ= Standard deviation of changes in the spot price ‘s’
  • σp = Standard deviation of changes in the futures price ‘f’

 

An optimal hedge ratio statistically aims to minimize the variance of a potential position’s value. It helps determine the “optimal” number of futures contracts to be bought or sold to carry out a position or hedge a position. Use the formula below to determine the optimal number of futures contracts to be bought or sold:

 

Optimal No. of Contracts - Formula

 

Hedge Ratio – Applications

The hedge ratio has a number of applications in the sphere of investment and finance:

 

1. Used as a statistical measure

The ratio is used as a statistical measure to evaluate the extent of risk of an investment that an investor might be exposed to while establishing a position.

 

2. Proves as a guideline

It proves as a guideline to investors in making informed investment decisions. Since it points towards the exposure to risk for establishing a certain position, it can serve as an investment guideline and help make informed decisions.

 

3. Used as a risk mitigation technique

Since hedge ratios help determine the level of exposure to risk, it serves as a crucial risk mitigation technique.

 

Related Readings

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

  • Hedging
  • Investing: A Beginner’s Guide
  • Risk
  • Variance Analysis

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