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Let’s learn about hedge ratio. Hedging is reducing or eliminating financial risk by entering into a transaction that will protect against loss through a compensatory price movement. It is the ratio of the size of position taken in the futures contracts to the size of the exposure in the underlying asset.
A hedge ratio is a mechanism for calculating the number of futures needed to hedge against the risk of loss in a portfolio of commodity derivatives. It is also known as a ‘delta’.
A delta is commonly used to compare the value of a position protected by a hedge with the size of the actual position. For instance, you need to calculate the number of options required to offset a change in value resulting from a price change in 10 commodities at a given point in time. If you need two options to offset the change, the delta is 2.
The hedge ratio also identifies and assists to reduce any risks in futures contracts. Hence, it may be utilized to compare the value of a commodity futures contract with the value of the underlying instrument that is being hedged.
It compares the value of a position protected through the use of a hedge with the size of the entire position itself. A hedge ratio may also be a comparison of the value of futures contracts purchased or sold to the value of the cash commodity being hedged
