Question

Discuss the following theoretical dimensions to currency hedging: optimal hedge ratio, hedge symmetry, hedge effectiveness and hedge timing. (There are as many different approaches to exposure management as there are firms and no real consensus exists regarding the best approach)

Answer 1

What is a Hedge?

• A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security.

Optimal Hedge Ratio

• 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.

Formula

Hedge ratio equals the value of the hedging instrument divided by the value of the hedged asset. It can be calculated using the following formula:

Hedge Ratio =	h	=	cu − cd
U	Uu - Ud

Where h is the exposure to the hedging instrument and U is the value of the underlying i.e. hedged asset. hu and hd represent the value of the hedging instrument (forward, option, etc.) when the value of the underlying (i.e. the hedged asset) goes up and down respectively. Similarly, Uu and Ud represent the value of the underlying asset (i.e. the hedged asset) in the up and down states.

Hedge Effectiveness and Timing:

Hedge Effectiveness:

• Hedge effectiveness is he extent to which changes in the fair value or cash flows of the hedging instrument offset the changes in the value or cash flows of the hedged item.
• Conversely, hedge ineffectiveness is the measure of the extent to which the change in the fair value or cash flows of the hedging instrument does not offset those of the hedged item.

Hedge timing:

• Timing is one of the most significant determinants of the outcome of a hedging strategy.
• Hedge if done properly will often achieve its primary goals: budget certainty. however budget certainty is not only goal sought by transit agencies.
• Typically, transit agencies also seek to hedge at aprice the will be lower than the marrket price or at least to avoid hedging at price that will be significantly above the market price.
• When and how agencies enter hedging positions will have an effecton whether the hedged price will be favorable or unfavorable to the market price.
• Timing issues are particularly important for forward price contracts becausee they lock in a price, thus preventing the agency from benefiting from price declinnes.