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Hedge Ratio Hedging is the art of reducing or eliminating financial risk by entering into a transaction that will protect

against loss through a compensatory price movement. A hedge ratio, therefore, is a mechanism for calculating the number of options or other derivatives, or amount of currency, needed to hedge against the risk of loss in a portfolio of shares or other derivatives. It is also known as a delta. A delta is commonly used to compare the value of a position protected by a hedge with the size of the actual position. For instance, you need to calculate the number of options necessary to offset a change in value resulting from a price change in 100 shares of common stock at a given point in time. If you need two options to offset the change, the delta is 2. To give a practical example, if you have a call option on shares for a particular company, a delta of 0.50 means that for every $1.00 increase in the share price, the option price rises by $0.50. The hedge ratio can also identify and help to minimize any risks in futures contracts. Thus, it may be used to compare the value of a futures contract with the value of the underlying instrument (for example a cash commodity or shares) that is being hedged. Indeed, a hedge ratio can be used to hedge any kind of financial instrument. The value of a delta is usually equal to a one-point change up or down in the underlying security over a short time period. If an option has a high delta, it is usually more profitable to purchase the derivative, as the greater percentage movement relative to the price of the underlying security offers better leverage. For derivatives with a low delta, the reverse is true and it is better to sell. For options, ratio between the change in an option's theoretical value and the change in price of the underlying stock at a given point in time. For convertibles, percentage of a convertible bond representing the number of underlying common shares sold against the shares into which bonds are convertible. If a preferred is convertible into 2000 common shares, a 75% hedge ratio would be short (long) 1500 common for every 1000 preferred long (short). Say 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 will help to identify and minimize basis risk. Hedge ratio The size of the position in futures contracts relative to the exposure (i.e., the value of the asset being hedged). More simply, the number of units of asset in futures contracts per unit of asset being hedged.

Optimum number of contracts Define: * NA = size of position being hedged (i.e., number of units of the asset being hedged). * QF = size of one futures contract (i.e., number of units of asset in one futures contract). * N = optimal number of futures contracts. Value of N is N = hNA/QF Cross Hedging Suppose now that the asset being hedged is different from the asset underlying the futures contract. When assets differ, one uses cross hedging. Example, Consider an airline that will purchase jet fuel. There are future contracts on jet fuel, so the airline chooses to hedge with a short position in heating oil futures. (in detail) The hedge ratio is the ratio of the size of the position in futures contracts to the size of the exposure. When the asset is the same as the futures contract, then the hedge ratio is 1.0. Not always optimal to choose the hedge ratio to be 1.0.

Optimal Hedge Ratio One problem with using futures contracts to hedge a portfolio of spot assets, is that a perfect futures contracts may not exist, that is, a perfect hedge cannot be achieved. For example, if an airline wishes to hedge its exposure to variation in jet fuel prices, it will find that there is no jet fuel futures market. A variation on the theme might go as follow. Although there exists a futures market for an underlying asset, that futures market is so illiquid that it is functionally useless. Thus, we need to find way to use sub-optimal contracts, contracts that are highly correlated with the underlying asset and who have a similar variance. This is achieved using the minimum variance hedge ratio.

The minimum variance hedge ratio (or optimal hedge ratio) is the ratio of futures position relative to the spot position that minimizes the variance of the position. The minimum variance hedge ratio is given as follows:

Where, is the correlation and

is the standard deviation

Let us take an example to understand this. An airlines company wishes to hedge their annual 2,000,000 gallons jet fuel requirement. In short they fear that the price of jet fuel will rise. Unfortunately, there exists no jet fuel futures contract. However, a futures contract for heating oil trades at the NYMEX (New York Mercantile Exchange) and, it is known that jet fuel is a derivative of heating oil.. The contract size of the NYMEX heating oil contract is 42,000 gallons. Thus, if heating oil were a perfect hedge, the Airline would purchase 2,000,000/42,000 contracts = 47.61 contract (either 46 or 47 contracts) Since heating oil is not a perfect hedge, they would use the minimum-variance hedge ratio to calculate the optimal number of contracts to purchase. i.e.,

The airlines company collects 15 months worth of data on spot jet fuel (S) and heating oil futures (F) prices. Month in Future Price (F) in Spot Jet Fuel Price (S)

0.021

0.029

0.035

0.020

-0.046

-0.044

0.001

0.008

0.044

0.026

- 0029

-0.019

-0.026

-0.010

-0.029

-0.007

0.048

0.043

10

-0.006

0.011

11

-0.036

-0.036

12

-0.011

-0.018

13

0.019

0.009

14

-0.027

-0.032

15 We calculate the following: F = 0.0313 S = 0.0263 = 0.928

0.029

0.023

So the Optimal number of contract is: = 37.14 Rounding, Airlines company would buy: 37 heating oil futures contracts If indeed jet fuel prices rose over the course of the year. The losses Airline would incur due to the higher spot jet fuel prices, would be offset by the gains they made from buying 37 contracts of heating oil futures. Ex. 2 - 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 between the two changes is 0.8. What is the optimal hedge ratio for a 3-month contract? 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.