Hedge ratio meaning

What is hedge ratio

A hedge ratio is the size of a hedge position divided by the size of the exposure it is meant to protect.

A hedge is a second position chosen to move against the first, so losses on one are partly offset by gains on the other. The hedge ratio tells you how much of the exposure that second position covers.

Hedge ratio formula

Basic (notional) hedge ratio:

Hedge ratio = value of the hedge position ÷ value of the exposure

• If the hedge equals the exposure, the position is fully hedged.
• If the hedge is smaller, it is a partial hedge. The uncovered part still moves with the market.
• If the hedge is larger, the position is over-hedged. The extra part is a new exposure in the opposite direction.

Minimum-variance hedge ratio (formal definition):

h* = ρ × (σS ÷ σF)

• ρ is the correlation coefficient between changes in the spot price and changes in the hedging instrument.
• σS and σF are the standard deviations of those changes. See annualized volatility.

This version gives the hedge size that, on historical data, minimises the variance of the combined position. It matters when the hedge instrument is not the same asset as the exposure.

Worked example (hypothetical)

A Pakistani importer owes an amount E in US dollars, payable in a few months. A weaker rupee would make that bill more expensive. This is currency risk.

The importer agrees a forward contract with a bank to buy dollars for an amount H, where H is smaller than E.

• Hedge ratio = H ÷ E
• Protected part: H, at the forward rate
• Unprotected part: E − H, at whatever the market rate is on the payment date

If the rupee weakens, the forward offsets the extra cost on H only. If the rupee strengthens, the importer gives up the benefit on H. To test different values of H and E, use the tools on the calculators page.

Where the term appears

• Company reports. Annual reports of airlines, importers and exporters often state what share of expected fuel or currency needs is hedged, under hedge accounting notes.
• Fund documents. Currency-hedged fund share classes describe a target hedge ratio against the base currency.
• News. Coverage of commodity producers and airlines often mentions hedge ratios when prices move sharply.
• Options. Delta is used as a hedge ratio: it shows how much of the underlying offsets a given option position.
• Trading platforms. MetaTrader accounts in hedging mode allow opposite positions on the same symbol. The platform does not show a hedge ratio field. You calculate it from the volumes and contract size.

Edge cases experienced traders watch

• Basis risk. The hedge and the exposure may not move together, so a full notional hedge can still leave losses.
• Cross-hedging. Hedging with a related but different asset needs the minimum-variance ratio, not the notional one.
• Unstable correlation. ρ estimated from past data can change, especially in stress periods.
• Rolling. Hedges with futures need rolling, which adds cost and timing risk.
• Cost of carry. Offsetting CFD positions can still be charged swap on both sides, and both sides carry spread costs.

Leveraged forex and CFD positions can lose money fast, and a hedge with the wrong ratio can add risk instead of reducing it. More on this in risk management.

Frequent questions

What does a hedge ratio show?

It shows how much of an exposure is offset by a hedge, as hedge size divided by exposure size.

Is a full hedge always the safest choice?

No. With basis risk or a cross-hedge, a full notional hedge may not minimise risk. The minimum-variance ratio accounts for correlation and volatility.

What is an over-hedged position?

It is a hedge larger than the exposure. The excess acts as a separate position in the opposite direction.

Is delta the same as a hedge ratio?

For options, delta is commonly used as the hedge ratio between the option and its underlying. It changes as price and time change.

Where can I find related terms?

See the trading glossary, and the pages on derivatives and counterparty.