Minimum-variance hedge ratio
Definition · Level 9 · Risk & portfolio
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The hedge size that leaves the smallest possible variance in the combined position: h* = correlation × (exposure’s volatility ÷ hedge’s volatility). What is left over is basis risk.
Example
Exposure volatility 24%, hedge volatility 16%, correlation 0.75 → short $1.125 of hedge per $1 of exposure.
Where Tradecraft teaches it
Level 9 · Risk & portfolio, in the lesson “Hedge ratios, basis risk & tail hedges”: Size a hedge from correlation and volatility, see what basis and counterparty risk leave, and budget a tail hedge.
Related terms
- Counterparty riskThe risk that the other side of a trade (a dealer, a broker or an over-the-counter (OTC) swap partner) fails to pay or deliver what it owes.
- Tail hedgeProtection against rare crashes, for example far out-of-the-money index puts (contracts that pay only if the index falls far).
- 1RThe dollar amount at risk on a trade (entry-to-stop distance × size), used as the unit for measuring every result.
- AlphaReturn earned above what the asset’s market exposure predicts: Rp − [Rf + β(Rm − Rf)].
- AnchoringFixating on an arbitrary reference price, such as your entry or a prior high, when judging what something is worth now.
- Annualizing volatilityTurning a daily volatility into a yearly one by multiplying by the square root of the number of trading days: σ annual = σ daily × √252 ≈ σ daily ×…