hedge ratio

Over the last few years, an increase in availability and use of derivative securities allowed agents to face price risk to lower exposure. The simplest methods to lower it, is hedging with futures contracts. The ratio of the number of units of future assets that are purchased relative to the number of units of spot asset – is called the hedge ratio.

This ratio is significant, in term of, calculation of volatility of portfolio returns and is used to minimize the variance of the returns of a portfolio containing spot and futures - that is called the optimal hedge ratio.

One can hedge investment portfolio asset allocation where the hedge ratio is determined by the size of the futures contracts relative to the cash transactions. Long and short hedges can be used for downside and upside risks.

• Short is used for future contracts and is applied in the condition when one wants to sell the asset in future.
• Long is an appropriate hedge in the case, one wants to buy an asset in future.

Such strategies are often not straightforward and there can be many conditions like

• The asset to be hedged might not be the same as the underlying future contract, in terms of, quality, weight, size, structure and other physical factors.
• The hedger may not be certain of when the asset will be bought or sold.
• Basis risk for such recommendations is determined by the cash money of the asset and the future rates.

If the hedged item is same as the underlying commodity in a futures contract, the cash and future rate will be identical or replicas, but there can be conditions when the strategy is not exactly a replication. In such cases, cross hedging can be employed.

Basis risk prevents replica where it is not considered optimal to cross hedge to the hedge ratio that equals 1.0.