Hedging of derivatives

Hedging means to create a portfolio that offsets the risk of the original exposure. As risk is measured by the fluctuation of the future cash flow, the goal of hedging is usually the reduction of the variance of the total portfolio's value. The first chapter of Daróczi et al. (2013) presents the optimal hedging decision in the presence of the basis risk, when the hedging instrument and the position to be hedged are different. This often happens at the hedging of commodity exposure, because commodities are traded on exchanges, where only standardized (maturity, quantity, and quality) contracts are available.

The optimal hedge ratio is the proportion of the hedging instrument as a percentage of the exposure that minimizes the volatility of the whole position. In this chapter, we will deal with the hedging of derivative positions, assuming that the underlying is also traded in the OTC market; therefore, there will be no mismatch between the exposure and the hedging derivative...