Hedge effectiveness

[wrongsaidfred]

Hi David,

In video 2011.T3.d, you give a formula for hedge effectiveness. Hull also gives a formula for hedge effectiveness but it is much different. His is just rho squared, using the hedge ratio from slide 45 in the video.

Are these two methods comparable/compatible? Hull states that rho squared is "the proportion of the variance that is eliminated by hedging." What exactly does the formula you gave us tell us?

Are there specific situations where we need to use one method or the other?

Thank you,
Mike

 

[David Harper CFA FRM]

Hi Mike,

Yes, another source of perennial confusion. The second is Geman's; they are actually compatible but it's not obvious. Can you look at this thread from last year where i show the mathy relationship:

http://forum.bionicturtle.com/viewthread/1880/

in short, the minimum variance is the optimal (special) case of Geman's.

(before you ask me, because i know you are alert to these issues: Geman's BASIC risk is a puzzle to me, I wish GARP would get rid of it ... i've actually written the author/publisher because i think it's possible Geman means "basis risk" rather than "basic risk" because i find no other reference to this term in my financial literature)

Thanks, David

 

[wrongsaidfred]

Very nice.

Thank you!

Mike