Question

We have h, the hedge ratio and want to find N, the optimal # of contracts.

N= (h x size of hedged position)/ size of futures contracts

However, in this case it is a cross-hedge so the hedged position and the futures contract are in different currencies.

So does it make sense if we divide lets say Swedish Krona by Swiss Franc?

Answer 1

Yes it does make sense because the measure is irrelevant while we go for the cross hedging. It is all about the co-relation between those two measures, we should choose the future contract of an asset that has higher positive correlation with our underlying asset. Measure of unit does not matter because it is all about the correlation and correlation is independent of the measurement scales. People finds the correlation between the Age of the person and Weight of the person so age we measure in years and Weight we measure in KG /Pounds so now, does it make a sense? Yes it does because the correlation is independent of the measurement variables. So we divide Swedish Krona by Swiss Fran, is does make sense.

I hope my efforts will be fruitful to you

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