how the hedge ratio works
imagine you are holding 10 000 in foreign equity which exposes you to currency risk you could enter into a hedge to protect against losses in this position which can be constructed through a variety of positions to take an offsetting position to the foreign equity investment if you hedge 5 000 worth of the equity with a currency position your hedge ratio is 0 5 5 000 10 000 this means that 50 of your foreign equity investment is sheltered from currency risk types of hedge ratiosthe minimum variance hedge ratio is important when cross hedging which aims to minimize the variance of the position s value the minimum variance hedge ratio or optimal hedge ratio is an important factor in determining the optimal number of futures contracts to purchase to hedge a position it is calculated as the product of the correlation coefficient between the changes in the spot and futures prices and the ratio of the standard deviation of the changes in the spot price to the standard deviation of the futures price after calculating the optimal hedge ratio the optimal number of contracts needed to hedge a position is calculated by dividing the product of the optimal hedge ratio and the units of the position being hedged by the size of one futures contract example of the hedge ratioassume that an airline company fears that the price of jet fuel will rise after the crude oil market has been trading at depressed levels the airline company expects to purchase 15 million gallons of jet fuel over the next year and wishes to hedge its purchase price assume that the correlation between crude oil futures and the spot price of jet fuel is 0 95 which is a high degree of correlation further assume that the standard deviation of crude oil futures and spot jet fuel price is 6 and 3 respectively therefore the minimum variance hedge ratio is 0 475 or 0 95 3 6 the new york mercantile exchange nymex west texas intermediate wti crude oil futures contract has a contract size of 1 000 barrels or 42 000 gallons 1 the optimal number of contracts is calculated to be 170 contracts or 0 475 15 million 42 000 therefore the airline company would purchase 170 nymex wti crude oil futures contracts 