To hedge both translation risk and economic risk we determine the optimal hedge ratio (h) comprised of a portion of the hedge ratio for translation risk (hT) and a portion of the hedge ratio for economic risk (hE). Hedging translation risk (hT) is hedging the full amount of the principal of SF 500,000 so hT = 1. The portion of the optimal hedge ratio for economic risk (hE) is the correlation between changes in asset and currency values. In Bowman’s calculation, the relationship between Swiss stock returns and the changes in the Swiss franc is 4% / −10% = -0.40 which is the portion of the optimal hedge ratio for economic risk (hE). To hedge both translation risk and economic risk we add hT and hE together to get the optimal hedge ratio h or 1 − 0.40 = .6. Thus 60% of the principal would be hedged, i.e. SF 300,000 |
