The ratio of exposure to a hedging instrument to the value of the hedged asset is called a hedge ratio. It compares the value of a position protected through the use of a hedge with the size of the entire position itself. It is the comparative value of the open position hedges with the position’s aggregate size itself. A ratio of 1 or 100 indicates that the position is fully hedge and a ratio of 0 indicates that it is not hedged at all.
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What does it indicate?
It is used for comparing the amount of position hedged with the entire position of the investor. A ratio of 1 or 100 indicates that the position is fully hedge and a ratio of 0 indicates that it is not hedged at all. When the hedge ratio approaches towards 1, it shows that their exposure with relation to the changes in underlying asset value goes down, and when it approaches towards zero, then the position will be an unhedged position.
Formula and Example:
The formula for hedge ratio is:
Value of the Hedge Position = Total value invested by the investor in the hedged position
Value of the total exposure = Total value invested by the investor in the underlying asset.
Mr. Murli is a resident of the United States and wants to invest his surplus amount outside the US. He researched the various options and found out that the Indian Economy is growing rapidly than the US. Mr. Murli invests in Indian Markets by constructing a portfolio of equities of Indian companies amounting to $200000. The foreign currency risk is involved due to investment in a foreign country. Due to this, the investor will be concerned about the devaluation of rupees against the USD. In order to protect himself against the foreign exchange risk, the investor decides to hedge $50000 of its equity position. On the basis of this information, we calculate the hedge ratio as follows:
Value of Hedge Position: $50000
Value of total exposure: $200000
Using the formula:
Hedge Ratio = Value of Hedge Position/ Value of total exposure
The hedge ratio for this investment is 0.25
Uses of Hedge Ratio:
- It is a statistical measure of risk that investor uses to take a set of positions in the market.
- It helps the investor in decision-making since this ratio tells the risk in a portfolio.
- It helps in measuring risk exposure, thus making it a risk mitigation technique.
Pros and Cons:
- Aggressive hedging investors use hedge ratios as guidelines for estimation and optimization purposes of the asset.
- Understanding and evaluating the hedge ratio is simple as it is based only on two parameters.
- It can help the investor in understanding their exposure at the time of establishing a position.
- In certain situations when futures are not available in the currency in which the investor has an exposure, there is a currency mismatch.
- Achieving a perfect hedge in real life is quite difficult.
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It is a mathematical formula that compares the value of the proportion of position, that is hedged to the value of the entire position. It helps in identifying and minimizing the risks involved in the contract. It is very crucial from a risk management point of view. However, an investor must not solely depend on the hedge ratio and consider various other strategies as well.
Author: Urvi Surti
About the Author:
Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).