Hedge Ratio

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.

BREAKING DOWN 'Hedge Ratio'

For example, imagine you are holding $10,000 in foreign equity, which exposes you to currency risk. If you hedge $5,000 worth of the equity with a currency position, your hedge ratio is 0.5 (50 / 100). This means that 50% of your equity position is sheltered from exchange rate risk. The hedge ratio is important for investors in futures contracts, as it identifies and minimizes basis risk.

Minimum Variance 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 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.

Optimal Hedge Ratio Example

For example, assume that an airline company fears that the price of jet fuel will rise after the crude oil market has been trading at depressed level. The airline company expects to purchase 15 million gallons of jet fuel over the next year and wishes to hedge its purchase. However, there are not enough futures contracts available to hedge the company's entire purchase. 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.

Over the past three years, the standard deviation of the percentage changes in crude oil futures is 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 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
  1. Buying Hedge

    A transaction that commodities investors undertake to hedge against ...
  2. Selling Hedge

    A hedging strategy with which the sale of futures contracts are ...
  3. Basis Risk

    The risk that offsetting investments in a hedging strategy will ...
  4. Cross Hedge

    The act of hedging ones position by taking an offsetting position ...
  5. Double Hedging

    Hedging a position by using futures and options, thereby doubling ...
  6. Short The Basis

    A futures strategy involving the purchase of a futures position ...
Related Articles
  1. Trading

    A Beginner's Guide To Hedging

    Learn how investors use strategies to reduce the impact of negative events on investments.
  2. ETFs & Mutual Funds

    Hedging With ETFs: A Cost-Effective Alternative

    The benefits of ETFs for hedging are clear and investors of all sizes are taking notice.
  3. Investing

    A Beginner's Guide To Hedging

    Hedging is a practice every investor should know about.
  4. Trading

    Hedging Basics: What Is A Hedge?

    This strategy is widely misunderstood, but it's not as complicated as you may think.
  5. Managing Wealth

    Hedging for Beginners: A Guide

    People hedge as insurance against market volatility. Anyone can do it; here's a primer.
  6. Managing Wealth

    Will Hedge Funds Be Around in 10 Years?

    Learn why some analysts see hedge funds as a dying breed, especially after a torturous January 2016 for fund managers around the world.
  7. ETFs & Mutual Funds

    For Maximum Market Returns, Get Creative With Hedges

    Proper hedges help to contain your losses while still allowing profits to grow.
  8. Managing Wealth

    How To Avoid Exchange Rate Risk

    What are the best strategies to avoid exchange rate risk when trading?
  9. Financial Advisor

    Why Hedge Funds Are Not Living Up to Return Hype

    Hedge funds are supposed to produce better returns while protecting your investments from the downside. Here's why they are not living up to their purpose.
  10. Investing

    HF Performance Report: Did Hedge Funds Earn Their Fee in 2015?

    Find out whether hedge funds, which have come under tremendous pressure to improve their performance, managed to earn their fee in 2015.
RELATED FAQS
  1. What happens if you don't hedge your investments?

    Learn the purpose, advantages and disadvantages of hedging, and find out how to utilize hedging to enhance an overall investment ... Read Answer >>
  2. How do hedge funds use short selling?

    Learn how hedge funds use short selling to profit from stocks that are falling in price. Explore different analytical techniques ... Read Answer >>
  3. What is a cross hedge?

    Cross hedging is when you hedge a position by investing in two positively correlated securities or securities that have similar ... Read Answer >>
  4. Can you invest in hedge funds?

    Read about what it takes to invest in a hedge fund, and learn how some investors find ways to indirectly capture a hedge ... Read Answer >>
  5. What does a hedge fund do?

    Read how hedge funds differ from other investment vehicles and how their investment strategies make them unique and potentially ... Read Answer >>
  6. Why do companies enter into futures contracts?

    Learn how companies use futures contracts for the purposes of hedging their exposure to price fluctuations as well as for ... Read Answer >>
Hot Definitions
  1. Frexit

    Frexit – short for "French exit" – is a French spinoff of the term Brexit, which emerged when the United Kingdom voted to ...
  2. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  3. GBP

    The abbreviation for the British pound sterling, the official currency of the United Kingdom, the British Overseas Territories ...
  4. Diversification

    A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique ...
  5. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  6. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
Trading Center