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Over the last few years, increased availability and use of derivative securities allowed agents to face price risk to lower exposure. The simplest method to lower it is hedging with futures contracts. The ratio of the number of units of future assets purchased relative to the number of spot assets – is called the hedge ratio.
This ratio is significant in terms of the volatility of portfolio returns. It is used to minimize the variance of the returns of a portfolio containing spot and futures - the optimal hedge ratio.
One can hedge investment portfolio asset allocation where the size of the futures contracts relative to the cash transactions determines the hedge ratio. Long and short hedges can be used for downside and upside risks.
Short is used for future contracts and is applied when one wants to sell the asset.
Long is an appropriate hedge if one wants to buy an asset in the future.
Such strategies are often not straightforward, and there can be many conditions like
The asset to be hedged might differ from the underlying futures contract regarding quality, weight, size, structure and other physical factors.
The hedger may not be certain when the asset will be bought or sold.
The basis risk for such recommendations is determined by the asset's cash and future rates.
If the hedged item is the same as the underlying commodity in a futures contract, the cash and future rate will be identical or replicas. Still, 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.
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