Hedge Ratio Definition
The hedge ratio is defined as the comparative value of the open position’s hedge with the position’s aggregate size itself. Also, it can be the comparative value of the futures contracts that are purchased or sold with a value of cash commodity that is being hedged. Futures contracts are an investment vehicle that allows the investor to lock the prices of the physical asset under consideration at some point in time in the future.
Hedge Ratio Formula
Given below is the formula of Hedge Ratio:
- Value of the Hedge Position = Total dollars which is invested by the investor in the hedged position
- Value of the total exposure = Total dollars, which is invested by the investor in the underlying asset.
The hedge ratio is expressed as the decimal or the fraction and used for quantifying the amount of the risk exposureAmount Of The Risk ExposureRisk Exposure refers to predicting possible future loss incurred due to a particular business activity or event. You can calculate it by, Risk Exposure = Event Occurrence Probability x Potential Loss that is being assumed by a person by remaining active in a trade or an investment. With the help of this ratio, an investor can have an understanding of their exposure at the time of establishing a position. The ratio of 0 means the position is not at all hedged, and on the other side, the ration of 1 or 100% shows that the position of the person is fully hedged.
When the hedge ratio of the investor approaches towards 1.0, then it shows that their exposure with respect to the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. goes down, and when the hedge ratio of the investor approaches towards zero, then the position will be an un-hedged position.
Hedge Ratio Example
Mr. X is a resident of the United States and is working there only. He has the surplus amount and wants to invest the same outside the United States as he is already having a good amount of investment in his home country. For the new investment, he conducted some study of the different foreign markets, and after studying, he found that the economy of country India is growing currently at a faster pace, which is even more than that of the United States.
So, Mr. X decides that he would participate in the Indian market, which is having higher than domestic growth, by constructing a portfolio of the equities having the Indian companies in that amounting $ 100,000. But due to this investment in a foreign country, the currency risk will arise as there is a currency risk involved whenever investment is made in non-domestic companies. So there is a concern of the investor over the devaluation of rupees against the U.S. dollar.
Now in order to foreign exchange riskForeign Exchange RiskForeign exchange risk is an unfavourable change in the settlement value of a transaction entered in a currency other than the base currency (domestic currency), also referred to as currency risk or exchange rate risk., the investor decides to hedge $ 50,000 of its equity position. Calculate the hedge ratio.
- Value of the Hedge Position = $ 50,000
- Value of the total Exposure = $ 100,000
So the calculation is as follows –
- = $ 50,000 / $100,000
- = 0.5
Thus the hedge ratio is 0.5
There are several different advantages of this ratio, providing the opportunity for the investors. Some of the advantages of the Hedge ratio are as follows:
- Parties that are involved in the practices of the aggressive hedging use hedge ratio as the guideline for the purpose of estimation and optimization of the performance of the asset.
- The hedge ratio is easy to calculate and evaluate as it involves the use of the two parameters, which are the Value of the Hedge Position and the value of the Total Exposure.
- With the help of the hedge ratio, an investor can have an understanding of their exposure at the time of establishing a position.
Drawbacks / Disadvantages
Apart from the advantages, there are different limitations and drawbacks, which includes the following:
- Sometimes there are situations when the futures are not present in the currency in which the hedger has the exposure. This leads to currency mismatch.
- The hedge ratio calculated should be close to the unity for attaining the perfect hedge, when calculated in the same currency. In other words, a perfect hedge in a futures contract is the same as underlying currency exposure. However, in real practice achieving a perfect hedge is quite difficult.
- It is used by the investors for comparing the amount of the position that is being hedged with respect to the entire position of the investor.
- The ratio of 0 means the position is not at all hedged, and on the other side, the ration of 1 or 100% shows that the position of the person is fully hedged. When the hedge ratio of the investor approaches towards 1.0, then it shows that their exposure with respect to the changes in underlying asset value goes down, and when it approaches towards zero, then the position will be an un-hedged position.
- The hedge ratio is hedged position, which is divided by total position.
Hedge Ratio is the mathematical formula that compares the value of the proportion of position, which is hedged to a value of the entire position. It helps the investor in understanding their exposure at the time of establishing a position. Like, if the hedge ratio that an investor has calculated comes to .60, then it shows that 60 % of the investment of the investor is protected from the risk, while the remaining 40 % (100 % – 60 %) is still exposed to the risk.
It is used for identifying and minimizing the risk present in the contract. Parties that are involved in the practices of the aggressive hedging use hedge ratio as the guideline for the purpose of estimation and optimization of the performance of the asset.
This has been a guide to what is Hedge Ratio and its definition. Here we discuss the formula of hedge ratio along with the example, advantages, and disadvantages. You can learn more about ratio analysis from the following articles –