Question

5. What is an optimal hedge and how do we calculate it? How do we decide if we should implement the hedge? Why?

Answer 1

I) Optimal hedge is a optimal contracts, contracts that are highly correlated with underlying assets and who have similar variance.

It is used to make investment to reduce the risk of adverse price movement on underlying assets by creating offsetting position.

II) Optimal hedge ratio is also called as minimum variance hedge ratio.

Optimal hedge ratio= p. * (S. D. Of Spot rate / S. D. Of futures rate)

Here, p. = correlation, S. D. = Standard deviation

Now, optimal hedge ratio is used to calculated optimal contracts

Optimal contracts = Optimal hedge ratio * (Portfolio size / Contract size of futures contract)

III) Hedge should be implemented using hedge ratio. This does not completely remove all risk of investments and hence hedge can be done on the basis of investors own tolerance level of risk.