Partial hedge

Hedging is not all or nothing. A business can cover part of its exposure and leave the rest open.

That is a partial hedge, and it is a deliberate choice, not a mistake. The workbook's case is an importer who was not sure about the rupee's movement, but was more biased towards rupee appreciation. If he thought he knew, he would hedge nothing. If he had no view at all, he would hedge everything. Because he half believed his view, he hedged half.

The result is a blend. The hedged part gets the rate the hedge produced. The unhedged part gets whatever the market gives on the day. The overall rate is the weighted average of the two, with the weights being the fractions covered and uncovered.

So a partial hedge sits between the two extremes. It always beats one of them and always loses to the other. Which one depends on where the rate ends up — and that is exactly the uncertainty the hedger was expressing.

There is a second, quieter reason partial hedges happen. Exchange traded contracts come in fixed lot sizes, so an exposure that is not a neat multiple of the lot cannot be covered exactly.

The workbook's framing (Chapter 5, section 5.2.2). The import example is introduced as a case where the hedger hedges only a partial amount of his total exposure, and the section says it will demonstrate the method of computing payoff when hedging is done for partial exposure.

The computation. The effective price is built in three steps:

The workbook states the key adjustment in words: since the importer hedged only half of the total exposure, the net inflow from hedging would be available for half of the total exposure.

Why anyone chooses it. Three reasons appear in the chapter, directly or by implication:

1. An uncertain view. The importer was biased towards rupee appreciation but not sure, and a partial hedge expresses exactly that.
2. A contingent exposure. Chapter 5, section 5.3.7.1, has the mango pulp exporter who sometimes cannot fulfil an order. The workbook's recommendation there is that the company could hedge a part of its exposure using currency options, specifically by buying puts, so that losses are limited to the premium if the goods cannot be supplied. A partial hedge and an option hedge address the same problem from two directions.
3. Lot size arithmetic. A USDINR contract is USD 1,000; a JPYINR contract is JPY 100,000. An exposure that is not a whole multiple leaves a residue uncovered whether the hedger intended it or not.

What is left uncovered is still risk. The three hedging decisions in section 5.2 — which contract, long or short, which contract month — do not include "how much", and the workbook never suggests a correct hedge ratio. It gives no recommended percentage, no minimum cover and no rule of thumb. The 50% in the example is that importer's judgement, not a prescription.

Related but not the same. A hedge can also be imperfect without being partial. Chapter 2, section 2.6, notes that standardisation may lead to an imperfect hedge as the amount and settlement dates cannot be customised, and that cash settlement in ETD may not be helpful to actual hedgers. That residual mismatch is basis risk, and it exists even at 100% cover.

The workbook's worked case. A pulses importer buys 1,000 tonnes of chickpea at USD 1,600 a tonne — USD 1.6 million. Spot USDINR on the contract date is 81. He hedges half the exposure with two-month futures at 81.50. Two months later the rupee has depreciated: spot 82.00, futures 82.05.

The three-way comparison the workbook draws:

The half hedge saved Rs 4.40 lakh against doing nothing, and cost Rs 4.40 lakh against full cover. It landed exactly in the middle, because half is exactly half.

Now suppose his view had been right. Illustrative counter-case, using the same contract rate of 81.50 and a rupee that appreciates instead. Spot at payment 80.50, futures 80.55.

The ranking has flipped completely. The partial hedge is second-best in both worlds — which is the whole point of it. An importer who is unsure buys the middle outcome and pays for it by never getting the best one.

Lot size residue. An exporter expecting EUR 2,50,500 faces a EURINR lot of EUR 1,000.

He is running a partial hedge of 99.8% whether he wanted one or not.

Chapter 5, section 5.2.2, is the partial hedge: the chickpea importer, the 50% cover, the 81.725 effective price and the explicit comparison with 81.45 for full cover and 82.00 for none. Section 5.3.7.1 applies the same idea through options for the mango pulp exporter. Chapter 2, section 2.6, supplies the separate point that standardised contracts can produce an imperfect hedge. Questions either ask for the weighted effective price or ask what happens to the uncovered portion. Remember the importer's sign: the futures gain is subtracted from the remittance rate before weighting.

• Weight the two rates by the fractions covered. Do not compute the hedged rate and present it as the answer, and do not take a plain average of the spot and futures rates.
• The futures payoff applies only to the hedged fraction. The workbook says the net inflow from hedging is available for half the total exposure, not all of it.
• The importer subtracts the futures gain; an exporter would add it. The sign convention does not change just because the hedge is partial.
• A partial hedge is never the best outcome and never the worst. If your answer beats full cover and no cover, something is wrong.
• There is no prescribed hedge ratio in the workbook. The 50% is that importer's choice; do not treat it as a rule.
• Partial hedge and imperfect hedge are different ideas. A partial hedge leaves part of the exposure uncovered by choice; an imperfect hedge arises from standardised amounts and dates, and leaves basis risk even at full cover.
• Lot size can create a partial hedge by itself — USD 1,000 for USDINR, JPY 100,000 for JPYINR.