# Minimum variance hedge ratio

What is the formula for this ratio? Many thanks!

H = Ht + He where He is (Cov (x,y) / variance) Ht = Transaction risk hedge and is equal to 1 He = Economic risk hedge and needs to be calculated

I thought Ht was called “translation risk”…someone please correct me if I’m wrong since I don’t know for sure and I think it came up on a Scheweser practice exam.

AFAIK it is translation risk, and i think i doubled checked it in CFAI

Yes, that’s right - sorry I just double checked too.

The follow up question: what is the difference between hedging translation and transaction risk? Use the Ht formula for translation and a plain vanilla currency swap for transaction?

what is transaction risk? is it something schwesers?

transaction risk: this is the risk when you are receiving cash flows each quarter for the widgets you are selling to brazil…

translation risk is the paper move of assets from one currency to another. i…e you’re company is based in new york but holds euro demonimated assets. When your company produces financial statements you have to translate the euro assets into dollars. generally this risk isn’t hedged as its paper transactions. transaction is you buy stuff from europe so you have to sell dollars and purhcase euro’s to make the transaction work. you can and often do hedge this risk. transaction risk, CSK, is in both CFAI and schwesers.

3rd & Long Wrote: ------------------------------------------------------- > transaction risk: this is the risk when you are > receiving cash flows each quarter for the widgets > you are selling to brazil… so transaction risk is hedged using translation risk + economic risk

no tranlsation risk is gernally not hedged and independent of transaction risk. see my post above for a better des.

comp_sci_kid Wrote: ------------------------------------------------------- > 3rd & Long Wrote: > -------------------------------------------------- > ----- > > transaction risk: this is the risk when you are > > receiving cash flows each quarter for the > widgets > > you are selling to brazil… > > so transaction risk is hedged using translation > risk + economic risk no. its actually copnfusing. in one ss they say transaction is the only risk to hedge. hedging eco risk is impossible and translation is not hedged. and this ss just states translation and economic completely forgetting transaction

bips Wrote: ------------------------------------------------------- > comp_sci_kid Wrote: > -------------------------------------------------- > ----- > > 3rd & Long Wrote: > > > -------------------------------------------------- > > > ----- > > > transaction risk: this is the risk when you > are > > > receiving cash flows each quarter for the > > widgets > > > you are selling to brazil… > > > > so transaction risk is hedged using translation > > risk + economic risk > > > no. > > its actually copnfusing. in one ss they say > transaction is the only risk to hedge. hedging eco > risk is impossible and translation is not hedged. > > and this ss just states translation and economic > completely forgetting transaction i want CFAI book and page #

look it up in the glossary - it’ll be there. might have to look under currency or hedging or something, but its there. don’t you trust us CSK?

Bips is right. In one SS it says to hedge transaction risk only and forget about translation and in another SS it says to hedge translation risk. I’m too annoyed to look up where each one was mentioned but I remember being pissed off by it.

we cant hedge translation risk (eg your subsidiary books is in FC and you consolidate their accounts to your local currency…the gain or loss is taken to currency reserve not to the consolidated PL)…hedging only applies to transaction risk (ie payment of raw mat in foreign currency - again note you hedge the purchase price and not the payment…the payment could be different! that is the economic risk and you see that in the PL called realised exchange gain or loss).

translation risk carries different meanings when it’s used in foreign security investment and in international company’s operation. according to cfai, 1) when used in the context of company’s opertaion, the translation risk (cfai calls it translation exposure instead) is about FX impact on consolidating financial statements; 2) when used in security investment, translation risk is about FX impact on total return. the minimum hedge ratio applies to the 2nd meaning only. in addition, economic risk (exposure) also carries double meanings for the two given situations. in context of company’s operation, it’s about company’s competittiveness against similar foreign companies given the FX uncertainty; while in context of security investment, economic risk is about uncertainty of capturing foreign G/L b/c of momvement of FX.

thanks rand0m, that clears it up!

LOTTIE Wrote: ------------------------------------------------------- > H = Ht + He where He is (Cov (x,y) / variance) > > Ht = Transaction risk hedge and is equal to 1 > He = Economic risk hedge and needs to be > calculated Sorry just to confirm (a bit confused here - cov / variance is like beta except for beta …cov is x or y against market index and var is the market variance): so the var here in cov (x,y) / var …is refering to var of market i presume? someone can clarify offhand?

I 2nd that. Clarification?