Illustrate the notion of “minimum variance hedge ratio” by means of a numerical example

Expert Solution

Minimum variance hedge ratio :

futures contracts to hedge a portfolio of spot assets, is that a perfect futures contracts may not exist, that is, a perfect hedge cannot be achieved. For example, if an airline wishes to hedge its exposure to variation in jet fuel prices, it will find that there is no jet fuel futures market. A variation on the theme might go as follow. Although there exists a futures market for an underlying asset, that futures market is so illiquid that it is functionally useless.

Thus, we need to find way to use sub-optimal contracts, contracts that are highly correlated with the underlying asset and who have a similar variance. This is achieved using the minimum variance hedge ratio.

The minimum variance hedge ratio (or optimal hedge ratio) is the ratio of futures position relative to the spot position that minimizes the variance of the position.

The minimum variance hedge ratio is given as follows:

jeff jeffy answered 2 years ago

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