Designing a Proper Hedge: Theory Versus Practice

Determining the hedge ratio based on the slope coefficient of a regression on price changes suffers from several critical shortcomings. First, it is difficult to assemble a properly constructed data set. Second, results vary depending on the length of the change interval. Third, the resulting ex post effective prices realized under this approach are wholly uncertain, ex ante. We show that when the hedge ratio is determined with reference to a regression on the respective price levels, rather than price changes, the resulting hedge ratio solution is superior in that none of these shortcomings apply.