FAQs on Hedging & Hedge Strategies: An Interim Report
Updated on: 20th May 2022
1. What is the Hedge Ratio?
Hedging in financial markets means protecting from risk or potential loss. It is a practice related to the Risk Management process. The hedge Ratio is a measure of a comparison between the protected position size and the total position size. It is the amount of protection offered in comparison to open positions/exposures.For example if you have a payable of EURUSD 10 Million and you have availed forward contracts for EUR 6 Million then your hedge ratio is 60%
Hedging a position is done generally through different financial instruments like forwards, options, swaps etc. At times hedging is done through set offs as well which is termed as natural hedging. For example, if a company has exports of EUR 10 Million, the company can avail an EUR Loan of 10 Million to offset the position.
The main purpose of hedging is risk management, and risk mitigation to some extent. The higher the Hedge Ratio, the higher the protection offered. An Optimal Hedge Ratio differs with a company’s objective, risk appetite, cost savings objective etc.
In Forex markets, hedging is done by corporations who have exposures in various currencies of the world, in the form of receivables or payables. Due to inherent volatility in currencies, hedging becomes an essential tool, in order to manage and mitigate risk. Hedging Ratio in Forex should always be kept according to a specific individual’s exposure in the specific currencies.
Hedge Ratio tells us the percentage of the exposure that a party has hedged using derivatives such as forwards, futures, options or swaps. The formula to calculate the hedge ratio for any party is stated below :
Hedge Ratio = Hedge Amount / Total Exposure
2. How to calculate Hedge ratios?
The formula to calculate hedge ratio:
Hedge Ratio = No. of positions hedged/Total No. of positions
3. What are some Hedge Strategies?
Hedging Strategies depend on the amount/type of exposure. For example:
- Long position hedges are done in an anticipation of the value of the asset to increase in the future.
- Short position hedges are done in an anticipation of the value of the asset to decrease in the future.
- Longer & Shorter tenor Hedges are done according to market movements and risk appetite. In case there is a clear anticipation of the asset moving upside or downside in the near-term, shorter-term hedges are more beneficial. Similarly, in case asset movements are expected to be highly volatile, longer-term hedges are considered a safer strategy, as positions can be squared off anytime.
- Conservative or aggressive hedging depends on the individual’s risk appetite. In the case of a highly risk averse individual, a conservative hedge strategy is considered more beneficial, and vice versa.
4. Types of Hedges?
- Static Hedging: It is a conservative hedging strategy, which involves hedging in the same lots, despite the market movements. This is considered to be a disciplined approach which focuses towards Risk Management only, and not cost savings.
- Dynamic Hedging: It is an aggressive strategy, as it might involve simultaneous buying and selling, in different lots, as the market moves. It may result in huge cost savings, and at times losses too.
5. Where can I get the Hedge ratio calculator?
One can get a Hedge Ratio calculator, simply by searching on Google, or apply this simple formula:
Hedge Ratio = No. of positions hedged/Total No. of positions
6. What are the applications and benefits of Hedge ratios?
- Used as a statistical measure:
The ratio is used as a statistical measure to evaluate the extent of risk of an investment that an investor might be exposed to while establishing a position.
- Proves as a guideline:
It proves as a guideline to investors in making informed investment decisions. Since it points towards the exposure to risk for establishing a certain position, it can serve as an investment guideline and help make informed decisions.
- Used as a risk mitigation technique:
Since hedge ratios help determine the level of exposure to risk, it serves as a crucial risk mitigation technique.
7. What is the optimal hedge ratio?
An optimal hedge ratio is a risk management ratio that determines the percentage of a hedging instrument, i.e., a hedging asset or liability that a risk manager should hedge. The ratio is also popularly known as the minimum variance hedge ratio. It is primarily used with the practice of cross hedging.
- ρ = The correlation coefficient of the changes in the spot and futures prices
- σs = Standard deviation of changes in the spot price ‘s’
- σp = Standard deviation of changes in the futures price ‘f’
An optimal hedge ratio statistically aims to minimize the variance of a potential position’s value. It helps determine the “optimal” number of futures contracts to be bought or sold to carry out a position or hedge a position
However, another way to look at optimisation of hedge strategy would be to have a hedge ratio that provides minimum risk and maximum savings. Something where the ratio of “expected savings from hedging” to “potential loss from open exposure” is the best. Actually the sharpe ratio or efficient frontier concept applies here for risk management.
8. What is a hedging horizon?
Depending on the nature and size of the exposures and their markets and risk cycle, many companies hedge between 1 and 3 years of exposure, with a declining proportion of net exposure hedged further out in time. There are three reasons for this approach:
- The size of the exposures in the near future is uncertain and though most forecasts anticipate top-line growth and declining costs, treasurers show reluctance to rush out and hedge the exposures implied by these financial plans.
- There is less certainty around expectations for the prices of their underlying assets further into the future. Greater consensus around nearer term rates makes nearer-term hedges seem safer and less controversial than long-dated ones, where there is a greater risk of a hedge going underwater.
- The bid-ask spread and cost of hedging the exposures, increases with the hedge horizon. Long-dated markets are less liquid and more expensive.
9. How to calculate the futures hedge ratio?
Futures hedge ratio is calculated as – Nominal amount to be hedged / value of one future contract
10. What is the link between hedge ratio and hedge efficiency?
Hedge effectiveness is the extent to which changes in the value of the financial derivative offset the opposing change in value of the given exposure. Hedge effectiveness is measured with three criteria:
Economic relationship – There must be an inverse relationship between the change in the value of the hedged item and the change in the value of the hedging instrument.
Credit risk – Changes in the credit risk of the hedging instrument or hedged item should not be large enough to dominate the value changes associated with the economic relationship.
Hedge ratio – The appropriate hedge ratio should be maintained throughout the life of the hedge. Without a significant hedge ratio being maintained the changes in value of the exposure and derivative will not offset each other.
11. What is the best hedging strategy?
There is no particular hedging strategy that is best. Every industry has a different risk cycle and companies within the same industry have different risk cycles. The company must be open to use all the derivatives instruments like forwards, futures, options and swaps. Hedging should not only be limited to the use of Forwards. The risk management policy of a company must provide flexibility to the risk manager to hedge the exposures according to the market’s outlook and the company’s risk cycle. Frequent review of the hedged positions and risk cycle must be performed.
12. How to use options as a hedging strategy?
Options give the buyer a right to buy or sell the underlying at a predetermined strike price on a particular date. There are two types of options, Call options and Put options. Call option gives the buyer a right to buy the underlying at the strike price on a particular date whereas Put option gives the buyer a right to sell the underlying at the strike price on a particular date. The option buyer needs to pay a cost for buying this right which in technical terms is known as the premium to the option writer. The premium is the hedging cost for the buyer. If the option buyer exercises their right then the option writer is obligated to sell or buy the underlying at that predetermined price and the premium is an inflow for the writer in any case.
Companies should have the flexibility and approval to use options for hedging purposes. If using options, companies must frequently review their positions and the underlying, and options must be used after thorough study and if need be after proper consultancy.