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Hedge Ratio

Moneyzine Editor
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Moneyzine Editor
1 mins
September 20th, 2023
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Hedge Ratio

Definition

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.

Calculation

Hedge Ratio = Dollars Hedge Position / Dollars of Exposure

Where:

  • 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.

Explanation

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.

Example

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

Related Terms

Hedge (Options)
The term hedge refers to a strategy that establishes a new position in an asset to protect the profitability of an existing position. While a hedge can be used to control risk, and lower a potential loss, that same hedge will also reduce potential gains.
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Gamma (Options)
The term gamma refers to the rate of change in delta for a one point change in the price of an underlying asset. An option's gamma is typically expressed in terms of a percentage change in delta for a one-point change in the underlying asset's price.
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Fungibility
The term fungibility refers to the interchangeability of assets due to standardization. Trading and exchange of an asset is simplified if it possesses the characteristic of fungibility.
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Expiration Friday
The term expiration Friday refers to the last business day an option can be sold, purchased, or exercised before it expires. Expiration Friday occurs each quarter, and is characterized by higher than normal price volatility and trading volumes.
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Expiration Date (Expiry Date)
The term expiration date refers to the final day the holder of an option contract can exercise their right under the agreement. After the expiration date, the seller of an option can no longer be assigned.
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Exercise by Exception (Automatic Exercise)
The term exercise by exception refers to the automatic exercise of in-the-money options at expiration. The Options Clearing Corporation (OCC) institutes exercise by exception unless explicit instructions prohibit exercising the option.
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European Option
The term European option refers to an agreement that can be exercised only on a specific day prior to its expiration date. Call or put options involving stock market indexes are typically European-style options.
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American Option
The term American option refers to an agreement that can be exercised at any time prior to, and including, its expiration date. Call or put options involving equities or common stock are typically American-style options.
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