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 various methods 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 a crucial factor in determining the optimal number of futures contracts required 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 crucial 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 the 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.
Related Terms: futures contracts, currency risk, cross-hedging, correlation coefficient, standard deviation.
References
- CME Group. “Crude Oil Futures Contact Specs.”
