Question

Let’s say you are going to hedge a portfolio and you remember the Greek Letters. What do you need to think about when you establish a hedge ratio? Hint: when might you need a “dynamic” hedging strategy versus “a hedge and hold” and how does that relate to the different inputs into Black-Scholes model.

Answer 1

An optimal hedge ratio (also called minimum-variance hedge ratio) is a ratio that tells use the percentage of our asset or liability exposure that we should hedge. It equals the product of the correlation between the prices of the hedging instrument and the hedged instrument and the volatility of the hedged instrument divided by the volatility of the hedging instrument. An optimal hedge ratio is most relevant where the characteristics of the hedged instrument and the hedging instrument are different i.e. in a cross hedge.

Optimal Hedge Ratio =ρ ×σp/σh

P= portfolio

h= hedged asset

Alternatively hedge ratio of an commodity can de derived by-

Hedge ration( commodity) =

(SD of portfolio* coefficient of correlation of P and h) / SD of h

Following the correlation analysis, which determines whether the futures contract is at all suitable for hedging the cash position, the number of required futures contracts (the hedge ratio) must be determined.The following factors generally play a role:

• Size of cash position
• Futures contract size
• Price sensitivity of the cash position
• Price sensitivity of the futures contract

Dynamic hedging strategy-

Dynamic Hedging is a foreign exchange management strategy that provides a flexible solution to protect investments from exchange rate risks as it allows businesses and individuals to readapt their hedging positions to evolving market conditions.

The Dynamic Hedging strategy differs to more static currency management schemes as they allow to readapt the hedging rate in parallel with the evolution of the FX markets.

This strategy, applied to international businesses exposed to FX volatility, allows them to hedge their exposure at rates that are closer to the current exchange rate.

For instance, businesses selling goods and services overseas and with prices in foreign currencies face continuous exposure to the fluctuations in the exchange rates of those currencies​​​​​​.