Benchmark hedge ratio definition
/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.
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Advantages of Using the Benchmark Hedge Ratio
There are several advantages associated with using the benchmark hedge ratio, which are as follows:
Reduces financial risk. By setting an optimal hedge ratio, a company can stabilize cash flows and earnings by reducing exposure to unpredictable price movements. This is especially useful for industries dealing with commodity prices, currency exchange rates, or interest rate fluctuations. A well-calculated hedge ratio helps protect profitability and financial stability.
Aligns with business strategy. The benchmark hedge ratio allows organizations to customize their hedging strategy based on their willingness to take on financial risk. A risk-averse company may choose a higher hedge ratio to ensure stability, while a company with a higher risk tolerance may hedge less to allow for potential gains. This flexibility helps firms balance risk management with growth opportunities.
Helps optimize hedging costs. Over-hedging can lead to unnecessary costs, while under-hedging leaves a company exposed to price swings. The benchmark hedge ratio ensures that the firm is hedging just the right amount, balancing cost-effectiveness and risk reduction. This helps companies avoid excessive hedging expenses while maintaining adequate protection.
Enhances investor and lender confidence. A well-managed hedging strategy using the benchmark hedge ratio signals to investors, lenders, and stakeholders that the company is proactively managing financial risks. This can lead to lower borrowing costs, improved credit ratings, and greater investor trust. Stability in earnings and cash flows makes the business more attractive to potential investors.