1. What is the Optimal Hedge Ratio?

The Optimal Hedge Ratio (HR) is the proportion of futures contracts needed to hedge against price risk in the spot market. It minimizes the variance of the hedged portfolio's returns.

2. How Does the Calculator Work?

The calculator uses the following formula:

Where:

• \( \text{Cov}(S, F) \) — Covariance between spot and futures prices
• \( \text{Var}(F) \) — Variance of futures prices

Explanation: The ratio represents how many futures contracts are needed to offset price movements in the spot position.

3. Importance of Hedge Ratio

Details: An accurate hedge ratio is crucial for effective risk management in commodities, currencies, and financial derivatives trading.

4. Using the Calculator

Tips: Enter the covariance between spot and futures prices and the variance of futures prices. Both values should be in decimal form.

5. Frequently Asked Questions (FAQ)

Q1: What does a hedge ratio of 1 mean?
A: A ratio of 1 means you should hold equal amounts in the spot and futures markets for a perfect hedge.

Q2: What if my hedge ratio is negative?
A: A negative ratio suggests an inverse relationship between spot and futures prices, requiring a short position in futures to hedge a long spot position.

Q3: How often should I recalculate the hedge ratio?
A: Recalculate whenever market conditions change significantly or at regular intervals (e.g., monthly).

Q4: What are the limitations of this approach?
A: Assumes linear relationship between spot and futures prices and constant volatility, which may not hold in all market conditions.

Q5: Can I use this for cross-hedging?
A: Yes, but effectiveness may be reduced if the assets aren't perfectly correlated.