Hedge Ratio

What Is the Hedge Ratio?

The hedge ratio compares the value of a position protected using a hedge with the size of the whole position itself. A hedge ratio may likewise be a comparison of the value of futures contracts purchased or sold to the value of the cash commodity being hedged.

Futures contracts are basically investment vehicles that let the investor lock in a price for a physical asset sooner or later.

The hedge ratio is the hedged position separated by the total position.

How the Hedge Ratio Works

Envision you are holding $10,000 in foreign equity, which uncovered you to currency risk. You could go into a hedge to safeguard against losses here, which can be built through various positions to take an offsetting position to the foreign equity investment.

In the event that 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 half of your foreign equity investment is sheltered from currency risk.

Types of Hedge Ratio

The base variance hedge ratio is important when cross-hedging, which plans to limit the variance of the position's value. The base variance hedge ratio, or optimal hedge ratio, is an important factor in deciding 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. Subsequent to working out the optimal hedge ratio, the optimal number of contracts expected to hedge a position is calculated by separating the product of the optimal hedge ratio and the units of the position being hedged by the size of one futures contract.

Illustration of the Hedge Ratio

Expect that an airline company fears that the price of stream fuel will rise after the crude oil market has been trading at depressed levels. The airline company hopes to purchase 15 million gallons of stream fuel over the course of the next year, and wishes to hedge its purchase price. Expect that the correlation between crude oil futures and the spot price of stream fuel is 0.95, which is a high degree of correlation.

Further expect the standard deviation of crude oil futures and spot stream fuel price is 6% and 3%, individually. Subsequently, the base 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. Consequently, the airline company would purchase 170 NYMEX WTI crude oil futures contracts.

Highlights

• The hedge ratio compares the amount of a position that is hedged to the whole position.
• The base variance hedge ratio decides the optimal number of options contracts expected to hedge a position.
• The base variance hedge ratio is important in cross-supporting, which expects to limit the variance of a position's value.