In the context of futures contracts, it is a small adjustment that has to be made to the formula used to calculate the optimal number of contracts for hedging a position. This adjustment aims to take into account the impact of daily settlement of futures. Mathematically, the tailing adjustment is given by:
where N* is the number of futures required for the hedge, h* is the hedge ratio that minimizes the variance of the hedged position, VA is the dollar value of the position being hedged, VF is the dollar value of one futures contract. Per se, the optimal hedge ratio can be figured out using the following equation:
where h* is the hedge ratio, ρ is the coefficient of correlation between σS, the standard deviation of the underlying price, and σF the standard deviation of the futures price.
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