How Is the ‘Hedge Ratio’ Calculated in a Minimum Variance Hedge?
The minimum variance hedge ratio is calculated to determine the optimal number of futures contracts needed to minimize the variance (risk) of the hedged position. The formula is: Hedge Ratio = (Correlation Coefficient between spot and futures returns) (Standard Deviation of spot returns / Standard Deviation of futures returns).
This ratio ensures that the hedge provides the highest possible reduction in overall price risk.
Glossar
Hedge Ratio
Calculation ⎊ The Hedge Ratio quantifies the necessary size of a derivative position required to offset the price risk inherent in an underlying asset or portfolio, representing the change in the derivative's price relative to the change in the underlying.
Variance
Dispersion ⎊ In cryptocurrency, options, and financial derivatives, variance quantifies the degree to which returns deviate from their expected value, representing the inherent uncertainty within an asset’s price movements.
Minimum Variance Hedge Ratio
Calculation ⎊ The Minimum Variance Hedge Ratio (MVHR) is a statistical calculation determining the optimal size of a futures or forward position required to minimize the variance of a hedged portfolio.
Hedge
Mitigation ⎊ A hedge, within cryptocurrency and derivatives markets, represents a strategic position established to offset potential losses stemming from adverse price movements in an existing asset or portfolio.
Minimum Variance Hedge
Allocation ⎊ The Minimum Variance Hedge, within cryptocurrency and derivatives markets, represents a portfolio construction technique focused on minimizing overall portfolio volatility by inversely weighting asset allocations to their individual risk contributions.