What is the Benchmark Hedge Ratio?

The benchmark hedge ratio is used to decide upon the targeted proportion of an asset that an organization should hedge in order to reduce the amount of subsequent price fluctuations. The ratio chosen is based on an organization’s appetite for risk, as well as its historical experience with asset price fluctuations in the past. The ideal benchmark hedge ratio is a ratio that balances the cost of the required hedge with the amount of risk reduction achieved by employing it. The ratio used may vary, depending on the asset class and the current market conditions.

A high-confidence currency forecast with little expected volatility should be matched with a higher benchmark hedge ratio, while a questionable forecast may justify a much lower ratio.

Example of the Benchmark Hedge Ratio

A company has foreign exchange exposure for a current obligation to pay a supplier in a foreign currency in 90 days (a booked exposure). The treasurer should decide what proportion of this exposure to hedge, such as 80% of the booked exposure. A gradually declining benchmark hedge ratio for forecasted periods is justifiable on the assumption that the level of forecast accuracy declines over time, so the treasurer should at least hedge against the minimum amount of exposure that is likely to occur.