In the trade of futures, equities and currencies, hedging plays a major role in the enhancement of market liquidity. Hedging is the act of taking a position in a financial product in order to reduce the degree of risk associated with holding a specific asset. Producers, banks, mutual funds and individual investors frequently hedge open positions in an attempt to limit the impact that pricing volatility may have on asset value.
There are countless ways to implement hedging strategies, limited only by the trader or investor's creativity. In an effort to promote an efficient alignment of risk and reward, a device known as a hedge ratio is implemented.
Hedge Ratio Defined
A hedge ratio is the comparative value of an open position's hedge to the aggregate size of the position itself. It is expressed as a decimal or fraction and is used to quantify the amount of risk exposure one has assumed through remaining active in an investment or trade.
The formula for the hedge ratio is:
Hedge Ratio = Value of the Hedge / Total Position Value
Agricultural producers are regular practitioners of hedging strategies. For instance, wheat farmers commonly take opposing positions in the futures market to offset risks associated with seasonal pricing volatility. A hedge ratio may be used to reference the wheat farmer's assumed risk via the following scenario:
- Crop yield is estimated to be 20,000 bushels of #2 Soft Red Winter (SRW) wheat.
- A short position of 3 SRW futures contracts (5,000 bushels per contract) is taken to hedge against negative pricing at harvest time.
- The prevailing market price of #2 SRW wheat is £3.000 per bushel on the cash market, and £3.467 per bushel for the related futures contract.
- The total crop value is £60,000.
- The value of the futures position is £52,000.
- The hedge ratio is £52,000 / £60,000. It may be expressed as 13/15, .87 or 87%.
In effect, the wheat farmer has limited the risk exposure at 13%. Depending on how the cash and futures markets perform over the course of the growing season, the 13/15 hedge ratio may prove to be either too large or small.
In most cases, the hedge ratio exists as a value expressed on a scale from 0 to 1. However, in the event that the value of the underlying asset experiences extraordinary degrees of volatility, the hedge ratio may exceed 100%.
Hedge Ratio Applications
Parties engaged in aggressive hedging practices use the hedge ratio as a guideline for estimating and optimising asset performance. In addition, statistical measures such as correlation coefficients, standard deviation, alpha and beta values can be incorporated into a comprehensive risk management plan.
Many strategies are extremely complex, combining active positions in various derivative and currency products to further mitigate assorted risks. For instance, the simple wheat farmer scenario outlined above may be further augmented by adding a foreign currency position and energy derivatives product to the hedge. No matter the asset or objective, consultation with an industry-specific market professional is typically the first step in developing a viable hedging strategy.
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Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…