Hedge Ratio Calculator
We have created this hedge ratio calculator to help you calculate the proportion of your investment portfolio that is hedged from investment risks. This metric can help you to assess how much of your portfolio is immune from certain risks in the market. You can check out our optimal hedge ratio calculator and risk calculator to understand more on this topic.
This article will explain what a hedge ratio is and how to calculate the metric using the hedge ratio formula. Furthermore, we will help you understand the concept by showing you some practical examples.
What is a hedge ratio? Hedge ratio definition
The hedge ratio is a metric that is widely used in optimizing a portfolio. The hedge ratio is defined as the proportion of the hedged value over the total portfolio exposure. We use it to analyze how much of the portfolio value is being hedged and is hence immune to losses.
In general, the higher the hedge ratio, the higher the proportion of the value of the portfolio that is hedged. This means that a greater proportion of the portfolio is immune to potential losses. However, it does not mean that the higher the hedge ratio, the better. This is because when a portfolio is hedged, it forgoes some upside potential. Thus, it is important to strike the correct balance between how much of the portfolio is hedged and un-hedged.
Don't worry if this still sounds confusing to you - everything will be clear when we explain the hedge ratio formula in the next section.
How to calculate the hedge ratio? Hedge ratio formula
To understand the hedge ratio calculation, let's take the Portfolio Alpha of Company Alpha as an example:
- Total exposure:
- Hedge position:
The hedge ratio calculator is based on three steps:
Determine the value of total exposure
The first step is to determine the value of the
Total exposureis the amount of money that is invested in the market. You can also check out our investment calculator.
For our example, the value of
Determine the value of the hedge position
The value of
hedge positionis the amount of investment value immune from investment risk.
hedge positionfor this example is
Calculate the hedge ratio
The final step is to calculate the
hedge ratio. You can do it using the hedge ratio formula below:
hedge ratio = hedge position / total exposure
For the investment in this example, the
$375,000 / $1,000,000 = 37.5%.
You can also use our hedge ratio calculator to obtain the same result immediately.
Hedge ratio calculator in practice. What are the advantages and disadvantages of the hedge ratio?
Now that you've learned about the hedge ratio definition and how to calculate the hedge ratio, let's discuss the advantages and disadvantages of using this metric:
Firstly, let's talk about the advantages of using the hedge ratio in practice. The hedge ratio is good at acting as a guideline to optimize the portfolio. Moreover, the hedge ratio formula is also easy to use and understand.
However, the hedge ratio also has some drawbacks. For example, some portfolio exposure might be able to be hedged easily in the market. Furthermore, as different investments have different optimal hedge ratios, it might be challenging to optimize the portfolio based solely on this metric.
Can hedge ratio be negative?
The short answer is no. As the value of the hedge position and the value of the total exposure is always positive, the hedge ratio can't be negative.
What is hedging?
Hedging is a form of risk management where the party eliminates the risks of huge losses at the expense of reducing some potential profits. Hedging is normally carried out by commodity producers such as crude oil companies.
What is a good hedge ratio?
There is no one good hedge ratio as it differs between investments. This is because different investments have different volatility. Furthermore, different investors also have different risk tolerances.
What is exposure?
Exposure is defined as the amount of investment value that an investor can lose. Generally, this means the total amount of money that the investor invests in the market since technically any investment value can go to zero.
How do I find hedge ratio?
The hedge ratio calculation requires 3 steps:
- Determine the value of total exposure.
- Determine the value of hedge position.
- Divide the hedge position by the total exposure to get the hedge ratio