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The hedge ratio is a measure used in risk management to determine the proportion of an asset position that should be hedged using derivatives. It helps investors manage potential losses by balancing exposure between the asset and its hedge.
A hedge ratio is a metric that shows the portion of a position which is protected (hedged) relative to the total exposure. It is used in risk management to see how much of an asset or liability is offset by another financial instrument intended as a hedge.
For example, if an investor holds shares worth ₹100,000 and uses futures or options to hedge ₹60,000 of that value, the hedge ratio is 0.6 (or 60 %). This indicates that 40 % of the position remains exposed to market risk.
Below is the basic formula commonly used:
Hedge Ratio = Value of Hedge Position ÷ Value of Total Exposure
Value of Hedge Position = monetary value of the hedging instrument(s)
Value of Total Exposure = value of the asset/liability being hedged
For instance, if ₹600,000 worth of futures contracts are used to hedge a ₹1,000,000 stock exposure, the hedge ratio = 0.6 or 60 %.
To calculate hedge ratio in typical scenarios:
Determine your exposure (e.g. a stock portfolio or foreign currency exposure)
Decide the hedging instrument (e.g. futures, options, forward contracts)
Compute value of hedge instrument you plan to use
Use the formula above to find ratio
In more advanced cases (e.g. minimum variance hedging) correlation, volatility, or covariance between hedged and hedging instruments may also be involved to find an optimal hedge ratio.
Here’s a worked‑through scenario:
| Scenario | Exposure (₹) | Hedge Instrument Value (₹) | Hedge Ratio |
|---|---|---|---|
Investor holds a stock portfolio |
₹500,000 |
₹300,000 |
0.6 (60%) |
Hedge ratio is useful because:
It quantifies how much risk is being offset
Used in designing hedging strategies aligned with a defined level of risk
Enables monitoring of hedge effectiveness as market moves
Allows partial hedging, which may reduce cost while still providing some protection
Some of the drawbacks and challenges are:
Assumes perfect correlation between hedged position and hedging instrument; in reality, correlation may change
Hedging instruments may carry cost (premium, margin) affecting net gain
Over‑hedging or under‑hedging can occur if inputs (valuation, volatility) are not accurate
Liquidity and timing mismatch may reduce effectiveness
The hedge ratio is a simple but powerful tool in risk management. It indicates how much of a position is covered by a hedge, allowing investors to balance protection and exposure. While its simplicity is an advantage, its accuracy depends on reliable inputs and being combined with broader risk‑analysis methods.
This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.
A hedge ratio of 1 (or 100 %) suggests full hedging — the hedged instrument covers the entire exposure. A lower ratio means part of the exposure remains unprotected.
It means the hedge is designed to cover all of the exposure; theoretically, it should neutralise risk from that exposure (ignoring costs or imperfect correlation).
It helps investors understand how much downside protection they have, allows designing cost‑efficient hedges, and enables measuring risk exposure realistically.
Yes, in some strategies hedge ratios can exceed 1 — for example, when over‑hedging or when using leverage or futures contracts that exceed the nominal exposure. But this increases complexity and potential risk.
Using futures to hedge a stock portfolio, using options (puts) to hedge downside risk in equity holdings, or hedging currency risk in foreign revenue streams are common examples.
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