Question

what is hedge ratio in option valuation and why it is called as hedge?
please explain in detail not only formulas
good answer will be appreciated
thanks in advance

Answer 1

What is hedge ratio in option valuation? A Hedge ratio is the ratio of exposure to a hedging instrument to the value of the hedged asset. A ratio of 1 or 100% means that the position is fully hedged and a ratio of 0 means it is not hedged at all. Hedge ratio is an important statistic in risk management because it tells us the extent to which the risk of any adverse movement in our asset or liability will be met by any offsetting movement in the hedging instrument. The hedge ratio changes due to changes in value of the hedging instrument and/or the hedged asset or liability. Static Hedge vs Dynamic Hedge There are two ways in which a hedge can be set up: A. Static hedge, or B. Dynamic hedge

In a static hedge, the number of hedging contracts is not changed over the course of the hedge in response to any movement in the values of the hedging instrument or the hedged asset. In a dynamic hedge, on the other hand, more hedging contracts are bought or sold to bring back the hedge ratio to the target hedge ratio. 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: h Cu - Cd Hedge Ratio = U | Uu - U Where h is the exposure to the hedging instrument and U is the value of the underlying i.e. hedged asset. hu and he 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, U, and Ud represent the value of the underlying asset (i.e. the hedged asset) in the up and down states.

Why it is called as 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. Hedging is reducing or eliminating financial risk by entering a transaction that will protect against loss through a compensatory price movement. It is the ratio of the size of position taken in the futures contracts to the size of the exposure in the underlying asset.