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Optimal Hedge Ratio

Optimal hedge ratio defines the futures market position that will simultaneously minimize the risk absorbed in the market.

What is the Optimal Hedge Ratio?

The key to any effective hedging is to find the perfect security to be used for Hedging. One of the ways of finding it is to use the Optimal Hedge Ratio. We can account for an imperfect relationship between the spot and future positions through the ratio as it considers the correlation between the two rates.

Example of Optimal Hedge Ratio:

The optimal Hedge Ratio is calculated using the following formula:
$ ρ= \frac{COV_{S,F}}{\sigma_{S}\sigma_{F}} $

Where,
ρ is the correlation between S and F
σS is the standard deviation of the spot price
σF is the standard deviation of future price

Let’s take an example of hedging security with covariance as 2, S as 1.2 and F as 1.5. Using the formula given above optimal hedge ratio can be calculated as below:

$ ρ= \frac{2}{1.2*1.5}= 1.11 $

Why is the Optimal Hedge Ratio important?

An optimal hedge ratio assists the investors in minimising the variance of the combined hedge position hence minimising the risk and making the hedge more effective and efficient.

Owais Siddiqui
1 min read
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