Updated July 21, 2023
Definition of Hedge Ratio
A Hedge ratio is a ratio that shows the value of an open position’s securitized with the equal size of the position itself. It is a ratio of the exposure to an instrument hedged to the value of the hedged asset. The ratio of zero means the position is not hedged and from ratio from 1 to 100 means the position is hedged up to such ratio.
The hedge ratio is an important measure as it tells us to what extent the risk to our assets or liabilities can be met by offsetting with the hedged instruments. Hedging refers to making investments to reduce the risk of adverse price movement on account of currency exposure. It involves, creating an offsetting position is a related asset or foreign of an existing position. The hedge ratio keeps on changing due to changes in the value of the instrument hedged.
Formula
Hedge Ratio can be calculated simply by dividing the value of a hedging instrument by the value of a hedged asset, i.e.
Where ‘h’ is the exposure to the hedging instrument and ‘u’ is the underlying asset value, i.e hedged asset.
Examples of Hedge Ratio
Examples are given below:
Example #1
Let say an Indian Company today on 31st Jan. are expecting a payment from its US customer of USD 47,500/- to be received on the 25th of March. The current rate for 1 USD to INR is Rs. 71/- But the Indian Company is not sure that it would remain the same in the coming period and therefore wants to hedge its position. Please explain how can the company hedge its position.
Solution:
The company is expected to receive the funds in March, therefore, the company should take the futures contract and sell a future contract for approximately the same amount which he is expected to receive in USD, i.e 47500*71 = INR 33,72,500/-
The co. should sell future currency contracts for USD 47,500 in the current market at the current rate. Therefore by taking this hedging position, he can assure himself the current rate of conversion of Rs. 71/- in the future as well when he is ought to receive his money from his customer in the future.
Example #2
Now, let’s take an example of a firm that wants to pay money to a US client for his services of USD 70,000/- on the 7th of June. The current rate of 1 USD is Rs. 71/-. He wants to hedge his position as he has reasonable reason and expectations that the USD rates will high and INR will fall in the future.
Solution:
The Indian firm has to make a payment of Rs. 49,70,000/-(71*70000) to its clients in the US for service availed. To hedge this position the firm should buy a forward currency contract @ 71/- so as to assure that on the date of payment he will pay on Rs. 49,70,000/-, only without taking into consideration the fluctuating market rate of that period or whatever the rate would be on the time of making payment.
He should by a Currency contract for June of USD 70,000/- to hedge its position for the future payments in foreign currency.
Application and Benefits of Hedge Ratio
The hedge ratio is applied very commonly these days to hedge their future contract receipts and payments. Nowadays parties are engaged in aggressively hedging practices. Hedging Ratio is now used as a guideline for estimating and optimizing assets performance and use of present money available with the entities.
Benefits of Hedging:
- Hedging is a technique through which the investor can reduce its losses from the daily fluctuating market.
- Hedging is a technique where an investor can himself fix a price to buy sell his product for a future contract based on the current market price.
- Hedging is a technique that is also helpful to the agricultural manufacturer, farmers as they can hedge their yield price based on the current market rate.
- Hedging can be done for currency, produce and for shares also.
- The hedge ratio is an important statistic for risk management.
Limitation of Hedge Ratio
Limitation of hedge ratio is given below
- Hedging also involves a cost that can eat the profits you make from hedging contracts.
- Hedging reduces risk and where the risk is reduced simultaneously the profits are also reduced.
- If the markets are good and you have already taken the hedging then the profits will be negligible.
- Hedging requires a higher amount of investments such as higher balance and capital value.
- Hedging requires good trading skills to get successful hedging returns.
Hedge Ratio vs Delta
Delta is a value which is quoted in decimals from 0 – 1 for call options and 0 – (-)1 for put options. Delta helps traders figure out the rate of change for an option compared to the underlying futures position. Delta also helps in figuring out the hedge ration for the traders. The traders want to hedge an option position against an underlying future contract. The underlying asset always have a 100 delta, the hedge ration here is determined by dividing 100 by the option delta.
The hedge ratio is a strategy to minimize the losses by taking a forward position in the market of the underlying assets. Hedging is done only when there are future deliveries available and the price is good in the current market so as to secure the current market rate with the fluctuating and uncertain future market.
Conclusion
Hedge Ratio is a ratio that determines how much hedging is required to secure the asset underlying from the future fluctuating market. Hedging helps to reduce the losses of the traders as these are strategies by which the traders can take opposite positions to curb their losses which can accrue due to the market fluctuating rates.
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