Benchmark Hedge Ratio
The Benchmark Hedge Ratio is a metric used to determine the optimal proportion of a financial asset that should be hedged in order to mitigate the risk of price fluctuations. It is based on historical data and is used as a benchmark for comparing the actual hedge ratio employed by investors. The goal of using a benchmark hedge ratio is to achieve a balance between risk reduction and cost-effectiveness of the hedging strategy. The ratio may vary depending on the specific asset being hedged and the market conditions.
In the context of the Benchmark Hedge Ratio, the treasurer is responsible for determining the appropriate proportion of exposure to hedge. For instance, they may decide to hedge 100% of the booked exposure and 50% of the forecasted exposure. As the benchmark hedge ratio for predicted periods is expected to gradually decrease over time due to decreasing forecast accuracy, the treasurer should at least hedge against the minimum amount of exposure that is anticipated to occur.
Consider yourself exposed to currency risk because you own $10,000 worth of foreign stocks. You might take an offsetting position to the foreign stock investment, which can be formed through several positions, to enter a hedge to protect against losses in this position.
Your hedge ratio is 0.5 ($5,000 / $10,000) if you hedge $5,000 of the equities with a currency investment. This indicates that you can protect from currency risk 50% of your foreign equity investment.
There are various types of benchmark hedge ratios that companies can use to manage their financial risks. Some of the most common types include:
- Fixed Hedge Ratio: A fixed hedge ratio is a predetermined percentage of the exposure that is hedged. For example, a company might choose to hedge 50% of its foreign exchange exposure using a fixed hedge ratio.
- Time-Varying Hedge Ratio: A time-varying hedge ratio takes into account the changing market conditions and adjusts the hedge ratio accordingly. This type of ratio can help companies to respond to changes in the market and reduce their risk exposure.
- Options-Based Hedge Ratio: An options-based hedge ratio uses options contracts to manage risk. This type of ratio can provide greater flexibility and reduce the cost of hedging compared to other methods.
- Value-at-Risk (VaR) Hedge Ratio: The VaR hedge ratio is based on a statistical measure of the potential losses that a company could face. This type of ratio can help companies to identify the level of risk that they are willing to take on and adjust their hedging strategy accordingly.
- Minimum-Variance Hedge Ratio: The minimum-variance hedge ratio is based on mathematical models that seek to minimize the variance of the portfolio returns. This type of ratio can help companies to reduce their risk exposure while maximizing their returns.
Let's say an airline company is concerned that the cost of jet fuel would increase after the crude oil market has experienced a decline. The airline firm wants to hedge the price of the 15 million gallons of jet fuel it anticipates purchasing during the upcoming year. Assume there is a 0.95 correlation between the spot price of jet fuel and crude oil futures, which is a high level of correlation.
Assume also that the standard deviations for spot jet fuel prices and crude oil futures are 3% and 6%, respectively. Therefore, 0.95 * (3% / 6%) is the minimum variance hedge ratio, or 0.475. The contract size for the NYMEX Western Texas Intermediate (WTI) crude oil futures contract is 1,000 barrels, which is equal to 42,000 gallons.
According to calculations, the ideal number of contracts is 170, or (0.475 * 15 million) / 42,000. As a result, the airline firm would buy 170 contracts for WTI crude oil futures on the NYMEX.
- The hedge ratio contrasts how much of a position is hedged with how much of the position is unhedged.
- The minimal variance hedge ratio aids in deciding how many options contracts are best to use to hedge a position.
- In cross-hedging, which tries to reduce the volatility of a position's value, the minimum variance hedge ratio is crucial.