What is hedge ratio?
Hedge ratio is the ratio of the size of position taken in the futures contracts to the size of the exposure in the underlying asset. For example, if the hedger’s exposure in the underlying was to the extent of 11 bales of cotton, the futures contracts entered into were exactly for this amount of cotton. We were assuming here that the optimal hedge ratio is one. In situations where the underlying asset in which the hedger has an exposure is exactly the same as the asset underlying the futures contract he uses and the spot and futures market are perfectly correlated, a hedge ratio of one could be assumed. In all other cases, a hedge ratio of one may not be optimal. The optimal hedge ratio gives that, minimizes the variance of the hedger’s position.
