The Optimal Hedging Strategy Template
is a simple tool, which automatically calculates the optimal percentage
of exposure to hedge and the resulting net economic savings. The template
utilizes a risk aversion factor to determine the percentage of exposure
to not to hedge, potentially saving considerable hedging costs.
The risk aversion Sigma represents the level of risk the firm is willing to undertake which translates into the maximum allowable probability of the entity not able to meet financial obligations in 10 years. The higher proportion of earnings exposed to total earnings with less internal diversification represents a higher potential for hedging gain.
The more volatile the hedging risk price, the more useful hedging is. In contrast, with more volatile earning that cannot be hedged, hedging is less useful as more earnings volatility is derived from other external factors. A higher the cost of capital for specified for the entity translates to higher savings by freeing up capital reserves.
The result gives the optimal proportion of exposure to hedge given all of the parameters specified. The net savings represent a pre-hedge capital reserve released (or redeployed) determined by the freed-up capital by the reduced volatility and size of reserves held. The optimal hedging strategy is derived via economic value added (EVA) after deducting the hedging cost and benchmarking the net savings against the risk exposure.