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The optimal hedge ratio: A solution, a conjecture, and a challenge

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  • William T. Smith

    (University of Memphis)

Abstract

Calculating the Optimal Hedge Ratio (OHR) is challenging for agricultural exporting countries. The alternatives have been either to rely upon closed-form solutions for the OHR that require unpalatable assumptions (quadratic utility, or CARA utility with Gaussian distributions) or to employ complicated numerical methods. This paper derives an approximate closed-form solution for “compact” distributions with “small” risks. Given empirical distributions of prices and quantities it requires simple calculations to arrive at the OHR for any desired class and calibration of risk preferences. To the extent that futures markets are unbiased, the solution also suggests that a simple minimum-variance calculation may be sufficient to calculate the OHR.

Suggested Citation

  • William T. Smith, 2022. "The optimal hedge ratio: A solution, a conjecture, and a challenge," Economics Bulletin, AccessEcon, vol. 42(2), pages 877-888.
    • Handle: RePEc:ebl:ecbull:eb-22-00083
    as

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    References listed on IDEAS

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    More about this item

    Keywords

    Optimal Hedge Ratio; Utility Function; Risk Management; Risk Aversion;
    All these keywords.

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • G1 - Financial Economics - - General Financial Markets

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