Choosing Hedge Ratios for Related Underlying Assets
Summary
The document discusses hedging exposure to oil prices with forward contracts and asks whether one contract per asset is automatically the right hedge. The responses emphasize that the appropriate ratio depends on the objective and on how well the forward matches the exposure in quantity and holding period. Contract count alone does not establish a complete hedge.
A perfect hedge over a specified period requires matching the asset quantity and the desired hedge duration. For example, an exposure of 105 barrels paired with a three-month contract covering 100 barrels calls for 1.05 contracts; if fractional contracts are unavailable, a residual exposure remains. The hedge also needs to be rolled when the intended holding period extends beyond contract maturity. The discussion addresses contract sizing and duration, but does not derive a statistical minimum-variance hedge ratio or account for basis risk between related instruments.
Key ideas
- The hedge ratio depends on the intended hedging objective.
- A contract should match the quantity of the underlying exposure and the desired holding period.
- A mismatch between exposure size and contract size leaves residual risk when fractional contracts are unavailable.
- A hedge sized for a fixed maturity may need to be rolled to maintain protection.
Tags
Full text
# What is the optimum hedge ratio when trying to hedge one underlying security with another which is similar in natural? # What is the optimum hedge ratio when trying to hedge one underlying security with another which is similar in natural? The question is specified as hedging exposure to oil prices using forward contracts on oil) My idea is that we can just purchase one forward contract for each asset,then it should be perfectly hedged, but I don't know if this is correct. ## Answer by Bob (score 1) https://quant.stackexchange.com/a/37648 If you goal is to by perfected hedges then purchase one forward contract for each asset make sense to me. Is that really the right goal? ## Answer by zsljulius (score 0) https://quant.stackexchange.com/a/37657 You are not clear on the objective of hedging. The key to hedging I think is to find a forward contract that: - Matches the exposure to the quantity of your asset - Matches the duration you want to hold your asset If one can find a forward contract that matches exactly on these two dimensions, then you have a perfect hedge for a certain period. The hedge ratio simply tells you how many forward contracts you need for this. For example, if you hold 105 barrels of oil, and you can only find a forward contract that represents 100 barrels of oil for 3 months, you need to short 1.05 contracts. You might not be able to get that 0.05 contract you want, and you are net long oil by 5 barrel. You don't have a perfect hedge in this case. Even if you can find a contract that matches the quantity, you are only perfectly hedged for 3 month, and 3 months later, you will want to roll for the new contracts of the desired duration.
Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.