Hedge Ratio
Hedge ratio (for an asset, such as commodities, stocks) comes into the picture when a certain asset does not have futures contracts on it. For example, an airline company wants to hedge against the price fluctuations of jet fuel. But there is no futures contract available on jet fuel. Therefore, the company can hedge (cross-hedge) by using the futures contract of another asset which is highly correlated with jet fuel, such as heating oil.
Another example could be, a farmer wants to hedge for the production of groundnuts, but he can trade futures contract of soybean due to the unavailability of the futures contract on groundnuts. There could be many similar examples from the perspectives of a trader, investor, farmer, manufacturing companies, and portfolio managers.
Put it simply, optimal or minimum variance HEDGE RATIO is the beta of the returns of the asset to be hedged (jet fuel) relative to the returns of the asset to be used for the hedge (futures contract on heating oil). Which is nothing but the correlation between the assets multiplied by the ratio of standard deviation of the returns of the asset to be hedged and the returns of the asset to be used for the hedge.
Correlation (jet fuel, futures heat oil)*std dev (jet fuel returns)/std dev(heating oil futures returns).
Hedge means making the beta zero. Meaning, If a portfolio is fully hedged, it implies that the beta of the portfolio has become zero (no effect of market movements on the returns of the portfolio). Hedge ratio is called efficient when the net gain is zero, i.e., loss in the spot market is set off by the gains in the futures market or vice versa.
Minimum variance hedge ratio has been explained in a very simple manner in MS Excel in these youtube videos (links are given below):
https://www.youtube.com/watch?v=p-bBbdvy7r8
https://www.youtube.com/watch?v=NcdZtCBrJbo
Hedge ratio (for an asset, such as commodities, stocks) comes into the picture when a certain asset does not have futures contracts on it. For example, an airline company wants to hedge against the price fluctuations of jet fuel. But there is no futures contract available on jet fuel. Therefore, the company can hedge (cross-hedge) by using the futures contract of another asset which is highly correlated with jet fuel, such as heating oil.
Another example could be, a farmer wants to hedge for the production of groundnuts, but he can trade futures contract of soybean due to the unavailability of the futures contract on groundnuts. There could be many similar examples from the perspectives of a trader, investor, farmer, manufacturing companies, and portfolio managers.
Put it simply, optimal or minimum variance HEDGE RATIO is the beta of the returns of the asset to be hedged (jet fuel) relative to the returns of the asset to be used for the hedge (futures contract on heating oil). Which is nothing but the correlation between the assets multiplied by the ratio of standard deviation of the returns of the asset to be hedged and the returns of the asset to be used for the hedge.
Correlation (jet fuel, futures heat oil)*std dev (jet fuel returns)/std dev(heating oil futures returns).
Hedge means making the beta zero. Meaning, If a portfolio is fully hedged, it implies that the beta of the portfolio has become zero (no effect of market movements on the returns of the portfolio). Hedge ratio is called efficient when the net gain is zero, i.e., loss in the spot market is set off by the gains in the futures market or vice versa.
Minimum variance hedge ratio has been explained in a very simple manner in MS Excel in these youtube videos (links are given below):
https://www.youtube.com/watch?v=p-bBbdvy7r8
https://www.youtube.com/watch?v=NcdZtCBrJbo
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