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Understanding Hedge Ratio

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Anshika

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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.

What is Hedge Ratio

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.

Hedge Ratio Formula

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 %.

How to Calculate Hedge Ratio

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.

Hedge Ratio Example

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%)

Importance of Hedge Ratio

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

Limitations of Hedge Ratio

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

Conclusion

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.

Disclaimer

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.

FAQs

How do you interpret the hedge ratio?

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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Hi! I’m Nupur Wankhede
BSE Insitute Alumni

With a Postgraduate degree in Global Financial Markets from the Bombay Stock Exchange Institute, Nupur has over 8 years of experience in the financial markets, specializing in investments, stock market operations, and project management. She has contributed to process improvements, cross-functional initiatives & content development across investment products. She bridges investment strategy with execution, blending content insight, operational efficiency, and collaborative execution to deliver impactful outcomes.

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