What is a Hedge Ratio?
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.
This ratio is crucial in risk management. It determines the optimal proportion of an asset to be hedged, minimizing potential losses due to price fluctuations. A proper hedge ratio ensures effective mitigation of risk while allowing exposure to potential gains, striking a balance between protecting investments and capitalizing on market opportunities.
Table of contents
- The hedge ratio, also known as the delta or beta, represents the ratio of the size of a hedging position to the size of the exposure being hedged.
- The hedge ratio is used to determine the appropriate amount of the hedging instrument required to offset the risk of the underlying asset.
- Typically, the hedge ratio is calculated using statistical methods or financial models based on factors such as historical price data, correlations, or regression analysis.
- A hedge ratio is a valuable tool for investors and traders to effectively manage risk and minimize potential losses in their portfolios.
Hedge Ratio Explained
The hedge ratio, also known as the optimal hedge ratio or the delta hedge ratio, is a key concept in risk management and is widely used in the realm of financial derivatives and hedging strategies. It refers to the proportion of a derivative contract, like options or futures, that should be held to offset the price risk associated with an underlying asset.
The primary objective of employing this ratio is to mitigate the impact of potential price fluctuations in the underlying asset. By holding an appropriate amount of the derivative contract, an investor or entity can offset potential losses in the value of the underlying asset due to adverse market movements. This allows them to lock in a certain level of price protection and stabilize their overall portfolio.
It is typically calculated using mathematical models and statistical techniques. It involves analyzing the correlation between the price movements of the derivative contract and the underlying asset. A perfectly hedged position would result in a hedge ratio of 1, implying a one-to-one relationship between the derivative and the asset’s price movements.
However, a benchmark hedge ratio of 1 is not always achievable due to factors like transaction costs, liquidity constraints, and market dynamics. As such, the hedge ratio may vary from situation to situation. Traders and investors often seek to find a balance between a higher ratio, which provides more protection but might limit potential gains, and a lower hedge ratio, which offers more exposure to potential gains but less protection.
Hence, this metric plays a vital role in risk management by determining the proportion of a derivative instrument needed to hedge against potential losses in the value of an underlying asset. It allows investors and entities to strike a balance between protecting their investments from adverse market movements and retaining the potential for gains. Properly calculated and applied, this ratio can help optimize investment strategies and improve portfolio stability.
Let us understand the formula used by a hedge ratio calculator which shall act as the basis for the related concepts.
- 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 a 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 ratio of 1 or 100% shows that the position of the person is fully hedged.
When the hedge ratio of the investor approaches 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 zero, then the position will be an un-hedged position.
Now that we understand the basics, formula, and related concepts of a benchmark hedge ratio, let us apply the theoretical knowledge to the examples below to gain a practical overview of the concept and its intricacies.
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 equities having Indian companies in that amounting to $ 100,000. But due to this investment in a foreign country, a currency risk will arise as there is a currency risk involved whenever investment is made in non-domestic companies. Hence, there is a concern of the investor over the devaluation of rupee 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
Therefore, the calculation is as follows –
- = $ 50,000 / $100,000
- = 0.5
Thus, the hedge ratio is 0.5
The hedge ratio for External Commercial Borrowings (ECB) by firms in India is calculated and estimated at 63 percent for periods of high volatility in ForEx market according to a working paper by the Reserve Bank of India (RBI).
In situations with high volatility, ECBs would want to revamp their exposure in financial and natural terms by hedging their exposure in the range of 63-66 percent. This would translate into the total cost of the loan by about 9% percent. In addition to this, this could reduce the ForEx risk by about 33% for these firms.
There are several different advantages of the hedge ratio calculator, 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 aggressive hedging use hedge ratio as the guideline for the purpose of estimation and optimization of the performance of the asset.
- This metric is easy to calculate and evaluate as it involves the use of two parameters, which are the Value of the Hedge Position and the value of the Total Exposure.
- With the help of this ratio, an investor can have an understanding of their exposure at the time of establishing a position.
Apart from the advantages, there are different limitations and drawbacks, which include the following:
- Sometimes there are situations when the futuresFuturesFutures refer to derivative contracts or financial agreements between the two parties to buy or sell an asset in a particular quantity at a pre-specified price and date. The underlying asset in question could be a commodity (farm produce and minerals), a stock index, a currency pair, or an index fund. 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.
Frequently Asked Questions (FAQs)
The hedge ratio, also known as the delta or the hedge effectiveness, has several applications in finance. It is primarily used in risk management and hedging strategies to determine the appropriate allocation of hedging instruments, such as options or futures contracts, to offset the price risk of an underlying asset. This helps investors and institutions minimize potential losses and stabilize portfolio returns.
An optimal hedge ratio refers to the ideal proportion of a hedging instrument that effectively mitigates the risk associated with an underlying asset. This metric provides the highest degree of risk reduction or the best balance between risk reduction and cost.
Yes, the it can change over time. The optimal hedge ratio is not fixed and can be influenced by various factors, such as changes in the market environment, volatility of the underlying asset, and the investor’s risk tolerance. As market conditions evolve, the correlation between the hedging instrument and the underlying asset may change, necessitating adjustments to the metric for effective risk management.
This has been a guide to what is a Hedge Ratio. Here we explain the formula of hedge ratio with the example, advantages, and disadvantages. You can learn more about ratio analysis from the following articles –