Optimal hedge ratio

A position undertaken by an investor that would eliminate the risk of an existing position, or a position that eliminates all market risk from a portfolio. In order to be a perfect hedge, a position would need to have a 100% inverse correlation to the initial position. As such, the perfect hedge is rarely found. A perfect hedge is an investment that offsets 100% of the risk inherent in another investment. To offset all risk, the correlation, or relative gain or loss in value, between the investments must be exactly opposite. High-risk investments typically offer high returns in order to attract investors, and hedging is often used to make a high-risk investment more secure while sacrificing a portion of the potential profit. To secure a perfect hedge, the cost to the investor might be too high, however. Expected profits may be eliminated or reduced to an unacceptably low level by the cost of the hedge.

Proportion of the exposure that should optimally be hedged is h=p * S.D of S S.D of F

where sS is the standard deviation of DS, the change in the spot price during the hedging period, sF is the standard deviation of DF, the change in the futures price during the hedging period r is the coefficient of correlation between DS and DF.

Suppose that the standard deviation of quarterly changes in the prices of a commodity is $0.65, the standard deviation of quarterly changes in a futures price on the commodity is $0.81, and the coefficient of correlation betweeen the two changes is 0.8. What is the optimal hedge ratio for a 3-month contract? What does it mean?

The optimal hedge ratio is 0.8 0.65/0.81 = 0.642.

This means that the size of the futures position should be 64.2% of the size of the companys exposure in a 3-month hedge.