hedgeratio

Hedgeratio, often written as hedge ratio, is the proportion of an exposure that is hedged using a derivative or other hedging instrument. The concept measures how much risk is offset by the hedge and is used to tailor the degree of protection to a specific risk tolerance or market view.

Calculation of the hedgeratio can be simple or more sophisticated. The simple form is h = value of the hedge position divided by the value of the exposure. For futures hedging, this translates to h ≈ (number of contracts × contract size) / exposure value. In more precise approaches, a regression-based hedge ratio uses the slope of a regression of changes in the hedged asset on changes in the hedge instrument to capture correlation and volatility. In equity or portfolio hedging, the hedge ratio often aligns with the asset’s beta relative to the hedge vehicle, such as an index.

Applications of hedgeratio include risk management for producers, consumers, and investors. It guides decisions on how many futures contracts, options, or other instruments to employ to offset price movements, interest rate changes, or currency risk. A hedge ratio of 1 indicates a full hedge, while lower values imply partial hedging.

Limitations and considerations include basis risk—the imperfect correlation between the hedge and the exposure—along with transaction costs, rollover risk, liquidity constraints, and changes in market conditions that can reduce hedge effectiveness over time.

See also: hedge ratio, basis risk, delta hedge, duration hedging.