The concept of hedge ratio (HR) is important in the sphere of finance. This term refers to the value of the proportion of a commodity (asset, position) that is hedged to the value of the commodity as a whole. The concept has a second meaning. This term also defines the relationship between the value of a futures contract and the value of the cash commodity that was protected (hedged) (Sornette, Ivliev, & Woodard, 2012). The concept has a practical value. It helps to assess the degree to which an investment is exposed to risk. In this short essay, the author explains the concept in detail and argues that accurate hedge ratio calculations help companies to assess the risks and make right decisions about credits and contracts.
Before going into details, one needs to explain what hedge means in the first place. Many of you have probably heard it before. Simply speaking, this term refers to an investment made to reduce the risk of price movements that may affect the asset (Drake & Fabozzi, 2010). In some way, the hedge is similar to insurance. It helps to reduce the risk while at the same time requiring some money to ensure this protection. It means that a company or individual needs to pay money even if no actual risks emerge. A perfect hedge is the one that protects the whole asset or commodity. In reality, however, this happens very rarely (Apte, 2010).
HR is calculated using a simple hedge ratio options formula or delta hedge ratio formula. HR on a futures contract, for example, can be calculated by dividing the value in future contract by the value exposed to currency risk. A perfect ratio is always close to unity. It is important to note that hedge ratio formula options may differ depending on the context, so these calculations should be performed by competent financial managers who know all ins and outs of the process. Substantial mathematical skills are needed to deal with hedge ratio options, so it is always better to use professional services.
Application in Practice
Hedge ratio is not a theoretical, useless concept that can be interesting to researchers only. In fact, it has a great practical value. As previously noted, it can help investors and business partners to assess the risks of a particular company by calculating the degree to which its assets are exposed to risk. For example, if HR is 76, it means that 76% of the assets (money) is protected from risks. HR, in this case, equals 0.76. The rest, however, remains exposed. Hedge ratio greater than 1 means that a company increases its exposure to risks, while the negative hedge ratio suggests that the company overhedges (Schroeck, 2002). A company with the high ratio is believed to be more attractive for investors and creditors since there is a low possibility that it will lose its assets due to the exposure to currency fluctuations or other issues.
One also needs to distinguish between in-the-money and at-the-money options (Ianieri, 2009). In the first case, a call option’s strike price is low. However, it does not mean that an individual or organization will profit. The option is worth exercising in this case. At-the-money means that the option’s strike price equals the price of the asset. There is also the out-of-the-money term. It refers to situations when the strike price is higher than the market price of the security (Ianieri, 2009). As one can see, there are many details one needs to know about hedges and hedge ratio, so when large assets are at stake, it is always better to ask for professional help.
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