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What is a Hedge Ratio?
Hedging is a popular way to protect investments. It helps in mitigating risks and provides optimum exposure to risks. When a portfolio is hedged, it is often required by the investors to know about the portion of the total portfolio that is risk protected. This is where the hedge ratio comes in.
In general, the hedge ratio is the ratio of the value of the investor’s open position to the overall position of the portfolio. In other words, the hedge ratio is the ratio of the open position to the overall position with a hedge to the total size of the population.
Optimal Hedge Ratio
Minimum variance or optimal hedge is a very crucial measure for managing risk. It shows the investor where his current position lies and the position, he needs to reach a hedge for optimum protection.
It defines the relationship between the spot instrument price and that of the hedging instrument. In general, it should be ideal for the investor to hedge the portfolio optimally to gain the maximum returns from his investment.
The formula of optimal hedge ratio is,
$$\mathrm{ρ \times \left(\frac{σ_{𝒔}}{σ_{𝒇}}\right)}$$
where,
ρ = the correlation coefficient of the change in the future and spot price
$𝝈_{𝒇}$ = the standard deviation of the change in the future price
$𝝈_{𝒔}$ = the standard deviation of the change in the spot price
Types of Hedging Strategies
Hedging strategies can be of two types −
Short Hedge − In such a hedging strategy, the investors take a short position to hedge the future or the commodity. This strategy is applied by investors when they want to sell the options in the future or when there is a chance of the share value going down in the future.
Long Hedge − In contrast to a short hedge, a long hedge requires the investor to take a long position to hedge the future or the commodity. This strategy is applied by investors when there is a need to sell the asset in the future or when they expect the price of the share to go up.
Importance of Hedge Ratio
The hedge ratio is a very convenient tool to measure risk. Ideally, every investor should be worried about their risks whatever their portfolio contains, and a hedge ratio can help them realize the risky portion of the portfolio. The hedging ratio offers an insight into the risk proportion of a portfolio offering the investor an idea to mitigate the risks and manage the portfolio efficiently.
The hedge ratio offers information on how a change in the assets or a liability would start the change in the hedging instrument. By calculating the asset’s valuation, the hedge ratio helps investors and analysts to make wiser investment decisions.
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