Table of Contents

Hedge Ratio: Definition, Calculation, and Types of Ratios

By

澳洲幸运5官方开奖结果体彩网:Will Kenton

Updated August 15, 2021

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Andy Smith

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Katharine Beer

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 compare the value of 澳洲幸运5官方开奖结果体彩网:futures contracts purchased or sold with the value of the ca✃sh c꧙ommodity being hedged.

Futures ✨contracts are essentially investment vehicles that let the investor lock in a price for a physical as♒set at some point in the future.

Important

The hedge ratio is the he🔜dged position divided by the total position.

Key Takeaways

The hedge ratio compares the amount of a position that is hedged with 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.

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 thi♐s position, which can be constructed through a variety of positions to take an offsetting position to the foreign equity investment.

If you hedge $5,00💜0 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 Ratios

The minimum variance hedge ratio is important when 澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网:correlation coefficient between the changes in the spot and futures prices and the ratio of the 澳洲幸运5官方开奖结果体彩网:standard deviation of the changes in the spot price to the standard ꦡdeviation 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.

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 hꦦedge 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 that 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 New York Mercantile Exchange (NYMEX) 澳洲幸运5官方开奖结果体彩网:West 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.

How Do I Calculate the Hedge Ratio?

Divide the hedged position by the total position, and the quotient ꦏis the hedge ratio.

Why Is a Minimum Variance Hedge Ratio Important?

The minimꦦum variance hedge ratio helps determine the optimal number of options contracts needed to hedge a position. The ratio is important in cross-hedging, which aims to minimize the variance of a po🔜sition’s value.

Is There Another Name for the Minimum Variance Hedge Ratio?

Yes. The minimum variance hedge ratio is also known as the optimal hedge ratio. 💞Either way you name it, it is an important factor in determining the o💜ptimal number of futures contracts to purchase to hedge a position.

The Bottom Line

The hedge ratio compares the amount of a hedged position with the entire position. It may also compare the value of futures contracts purchased or sold with the value of the cash commodity being hedged.

Article Sources

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