HEDGE RATIO

&
CROSS HEDGING

Hedge Ratio
The hedge ratio is the ratio of the size of the
position taken in futures contracts to the size of
the exposure.
A ratio comparing the value of a position
protected through a hedge with the size of the
entire position itself.
Say you are holding $10,000 in foreign equity.
You are exposed with the currency risk. If you
hedge $5000 equity position with your currency
position your hedge ratio is 0.5 (50/100). This
means that 50% of your equity position is
hedged.

Hedge Ratio (Contd.)

The higher the hedge ratio, the less risk the
investor faces
However a higher hedge ratio also means lower
potential profits if the investment performs as
hoped
Up to now we have always used a hedge ratio of
1.
The hedge ratio is important for investors in
future contracts as it will help to minimize basis
risk

Cross Hedging
One of the difficulties of using futures contracts
to hedge a portfolio of spot assets, is that a
perfect futures contracts may not exist. 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.
Although there exists a futures market for an
underlying asset, that futures market is so illiquid
that it is functionally useless.
Therefore we will do cross hedging

Cross Hedging
When doing hedging, the underlying assets of
futures and original investment assets are
different, this type of hedging is called cross
hedging
If both the positions are in the same commodity
then we bear the loss and profit proportionally
but when futures contract is not available for the
same commodity we go for cross hedging.
Cross hedging give rise to basis risk, for which
we calculate the minimum variance hedge ratio

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.
It incorporates two variables
Volatility of two types of assets
Correlation in the price movements of the two
assets

Minimum Variance Hedge Ratio

Notations we are going to use are,
S = change in Spot Price S, during a period of time
equal to the life of the hedge
F = change in Future Price, F, during a period of
time equal to the life of the hedge
s = Standard deviation of S
F = Standard deviation of F
= Coefficient of correlation between S and F
h*= hedge ratio that minimizes the variance of the
hedgers position

Minimum Variance Hedge Ratio

The minimum variance hedge ratio is
given as follows:
S
h .
F

Optimal No. of Contracts in Cross

Hedging
Since cross hedging does not create a
perfect hedge, therefore we need to
calculate the optimal number of contracts
to purchase,
Optimal no. of contracts N* = h NA / QF
N* = Optimal number of future contracts for hedging
NA = size of position being hedged (Units)
QF = Size of one future contract (Units)

Example
Squirrel Air operate the prestigious Olean/Buffalo Air Shuttle
(OBAS). They wish 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, Squirrel Air would purchase
2,000,000/42,000 contracts = 47.61 contract (either 46 or 47
contracts)
Since heating oil is not a perfect hedge, we are going to
calculate the optimal no of contracts

Example
F = 0.0313,
S = 0.0263
= 0.928
Utilizing these figures we are going to
calculate the optimal number of contracts
for the Airline to hedge itself.