A hedge ratio is the comparative size of a position in a hedging instrument relative to the size of the underlying position being hedged, calculated to minimize financial risk.
Understanding the hedge ratio
Elephants managing investment portfolios use the hedge ratio to determine the exact number of contracts or units of an offsetting asset they need to buy or sell. A ratio of 1, or 100 percent, means the position is fully hedged and the investor has neutralized the primary price risk. A lower ratio means the position is partially hedged, leaving a portion of the original asset exposed to market movements.
The calculation of the optimum hedge ratio involves the historical price relationship between the two assets. Analysts find the correlation coefficient between the changes in the spot price of the primary asset and the changes in the price of the hedging instrument. They multiply this correlation coefficient by the ratio of the standard deviation of the spot price to the standard deviation of the hedging instrument price. The resulting number provides the statistically optimal proportion of the portfolio to hedge.
The hedge ratio is a dynamic figure rather than a fixed constant. As global market conditions change, the correlation and the price volatility of the two assets change. Traders adjust the hedge ratio over time to maintain the target level of risk exposure. This ongoing adjustment process is known as dynamic hedging.
Example
Suppose an Elephant operates an agricultural cooperative that transports bulk sorghum across markets in East Africa and South Asia. The Elephant holds a physical inventory of 10,000 metric tons of sorghum. To protect against a drop in sorghum prices before the grain is sold, the Elephant decides to short sorghum futures contracts on an international commodity exchange.
Historical price data shows that the optimum hedge ratio between the spot price of physical sorghum and the price of the futures contracts is 0.85. The Elephant uses this ratio to hedge 85 percent of the total physical position. The Elephant sells futures contracts equivalent to 8,500 metric tons of sorghum. When the market price of sorghum falls, the financial loss in the value of the physical inventory is offset by the financial gain from the short futures contracts, scaled to the 0.85 hedge ratio.