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What is the hedge ratio? Explain its advantages and disadvantages.
Hedge ratio is a ratio of value of hedge position to the value of total exposure. Value of hedge position is the total amount invested by investors in hedged position and value of total exposure is total amount invested by investor in underlying assets.
Hedge ratio also can be a comparative value of future contracts, which are sold or purchased with change in value of cash commodity that are being hedged. Hedge ratio is expressed in decimal or fraction. If value is zero means, position is not at all hedged, similarly, if the value is one means, position is fully hedged.
Investor point of view
If the hedge ratio is one, it tells exposure with the underlying asset goes down, similarly, if the ratio is nearing zero, it tells un-hedged position.
The formula to calculate the hedge ratio is given below −
Hedge ratio = HPv/TEv
Here, HPv = value of hedge position
TEv= value of total exposure
Advantages
The advantages of hedge ratio are as follows −
Party uses this in estimation and optimisation of performance of assets.
Easy to calculate.
Investors can understand exposure at the time of establishing a position.
Disadvantages
Given below are the disadvantages of the hedge ratio −
Sometimes the hedge ratio leads to currency mismatch.
Perfect hedge is difficult to achieve in real life.
Example
A person from the US wants to invest a sum of $150000 in Indian market by constructing an equities portfolio in Indian companies. Due to currency risk (devaluation of rupee to US dollar) he decides to hedge $ 75000 of its equity position. Calculate hedge risk.
Solution
The solution is given below −
Value of hedge position = $75000 Value of total exposure = $150000 Hedge ratio = HPv/TEv = 75000/150000 = 0.5 Here HPv = value of hedge position TEv= value of total exposure.
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