The term hedge ratio refers to a mathematical formula that compares the value of a hedge to the value of the position in an asset. Calculating and tracking hedge ratios allows investors to understand and control their exposure to the price volatility of various assets.
Hedge Ratio = Dollars Hedge Position / Dollars of Exposure
- Dollars of Hedge Position is equal to the total dollars invested in a hedged position
- Dollars of Exposure is equal to the total dollars invested in the underlying asset.
Calculating a hedge ratio can help the investor to understand their exposure when establishing a position. Typically used in the context of stock options, the term can also refer to futures contracts and commodities. As the investor’s hedge ratio approaches 1.0, their exposure to changes in the value of the underlying asset goes down. In the same fashion, when a hedge ratio approaches zero, the investor is said to have an unhedged position.
The economy of China is currently growing faster than that of the United States. An investor decides they would like to participate in that higher-than-domestic growth by assembling a portfolio of equities consisting of Chinese companies in the amount of $200,000.
This individual also understands there is currency risk whenever investing in non-domestic companies and there is a concern over the devaluation of the yuan against the U.S. dollar. To reduce their foreign exchange risk, the investor hedges $100,000 of their equity position; thereby establishing a hedge ratio of:
= $100,000 / $200,000, or 0.5