Fx Hedge Ratios

Hedging in financial markets means protecting from risk or potential loss. It is a practice related to the Risk Management process. The Hedge Ratio is a measure of a comparison between the protected position size and the total position size. It is the amount of protection offered in comparison to open positions/exposures. For example, if you have a payable of EURUSD 10 Million and you have availed forward contracts for EUR 6 Million then your hedge ratio is 60%

 Hedging a position is done generally through different financial instruments like forwards, options, swaps etc. At times hedging is done through set-offs as well which is termed as natural hedging. For example, if a company has exports of EUR 10 Million,  the company can avail a EUR Loan of 10 Million to offset the position. 

 The main purpose of hedging is risk management, and risk mitigation to some extent. The higher the Hedge Ratio, the higher the protection offered. An Optimal Hedge Ratio differs with a company’s objective, risk appetite, cost savings objective etc. 

 In Forex markets, hedging is done by corporations who have exposures in various currencies of the world, in the form of receivables or payables. Due to inherent volatility in currencies, hedging becomes an essential tool, in order to manage and mitigate risk. Hedging Ratio in Forex should always be kept according to a specific individual’s exposure to the specific currencies. 

Third Currency Hedge

Hedging through a currency in which there isn’t any exposure, in order to gain as the market moves. For example: hedging GBPINR risk through GBPUSD instead of GBPINR, in order to capture market movements. This is useful in certain scenarios. For example, if a company has Exports in USDINR and imports in GBPINR then by buying GBPUSD, it can convert the import into USDINR and then can set off against the export exposure. 

Hedge Ratio Formula

Hedge Ratio = No.of positions hedged/Total No.of positions

Hedge Ratio tells us the percentage of the exposure that a party has hedged using derivatives such as forwards, futures, options or swaps. The formula to calculate the hedge ratio for any party is stated below :

Hedge Ratio = Hedge Amount / Total Exposure 

The company or the investor might want to maintain either a constant hedge ratio or a dynamic hedge ratio. In a constant hedge ratio, the hedge ratio % is not changed over the period of time taken into consideration. Companies or investors might want to maintain a constant hedge ratio because of their risk management policy. The hedged amount is changed proportionally with the change in the total exposure to maintain a constant hedge ratio. 

If the company or the investor is maintaining a dynamic hedge ratio then they don’t have any obligation or requirement to maintain a fixed hedge ratio. The change in hedged amount is not proportional to the change in the total exposure. The hedged amount varies over time depending on the analysis, outlook and market conditions. 

The laddering hedge strategy is used primarily by investors or companies with exposure to bonds. It involves buying bonds with different maturities under a single portfolio. It helps them respond quickly to the changes in interest rates and reduces the reinvestment risk of rolling over frequently. A ladder strategy is also used via exotic options wherein the partial profits are locked in once the asset breaches a particular predetermined level.  

The laddering hedge strategy is often used by corporations where they apply higher hedge ratios for shorter time buckets and lower hedge ratios for longer time buckets. As time passes, longer exposures shift into shorter tenors requiring an appropriate increase in hedge ratio.  The table below explains the laddering hedge ratio – 

An optimal hedge ratio is a risk management ratio that determines the percentage of a hedging instrument, i.e., a hedging asset or liability that a risk manager should hedge. The ratio is also popularly known as the minimum variance hedge ratio. It is primarily used with the practice of cross-hedging.

Where:

• ρ = The correlation coefficient of the changes in the spot and futures prices
• σs = Standard deviation of changes in the spot price ‘s’
• σp = Standard deviation of changes in the futures price ‘f’

 An optimal hedge ratio statistically aims to minimize the variance of a potential position’s value. It helps determine the “optimal” number of futures contracts to be bought or sold to carry out a position or hedge a position

However, another way to look at optimisation of hedge strategy would be to have a hedge ratio that provides minimum risk and maximum savings.  Something where the ratio of  “expected savings from hedging” to “potential loss from open exposure” is the best.  Actually, the sharpe ratio or efficient frontier concept applies here for risk management.