# Hedge Ratio: Definition, Calculation, and Types of Ratios

![Hedge Ratio](https://www.investopedia.com/thmb/2vY9ApsGyF81HM2o6ZwcEReJ0Z0=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/HedgeRatio_final-7be2784df9a340728ed86427cccc80ad.png)

*— Nez Riaz / Investopedia*

> **Definition**
>
> The hedge ratio plays a crucial role in risk management by comparing the value of a protected position to the entire investment. This measure can also apply to futures contracts related to the cash commodity they hedge. Understanding the hedge ratio is essential in scenarios like currency risk where it determines the extent of protection. For example, holding $10,000 in foreign equity while hedging $5,000 offers a hedge ratio of 0.5, safeguarding half the investment from currency fluctuations.

## What Is the Hedge Ratio?

The hedge ratio compares the value of a position protected through the use of a [hedge](https://www.investopedia.com/terms/h/hedge.asp) with the size of the entire position itself. A hedge ratio may also compare the value of [futures contracts](https://www.investopedia.com/terms/f/futurescontract.asp) purchased or sold with the value of the cash commodity being hedged.

Futures contracts are essentially investment vehicles that let the investor lock in a price for a physical asset at some point in the future.

> **Important**
>
> The hedge ratio is the hedged position divided by the total position.

### Key Takeaways

*   The hedge ratio measures the portion of a position that is protected via a hedge compared to the total position.  
    
*   Calculating the hedge ratio involves dividing the hedged position by the total position, providing insight into the level of risk management.  
    
*   The minimum variance hedge ratio is crucial for determining the optimal number of futures contracts needed to effectively hedge a position.  
    
*   A correct hedge ratio can significantly reduce the risk associated with currency or commodity price fluctuations.  
    
*   Understanding the hedge ratio helps investors make informed decisions when managing exposure to financial risks.

## Understanding the Functionality of Hedge Ratios

Imagine you are holding $10,000 in foreign equity, which exposes you to [currency risk](https://www.investopedia.com/terms/c/currencyrisk.asp). You could enter into a hedge to protect against losses in this position, which can be constructed through a variety of positions to take an offsetting position to the foreign equity investment.

If you hedge $5,000 worth of the equity with a currency position, your hedge ratio is 0.5 ($5,000 / $10,000). This means that 50% of your foreign equity investment is sheltered from currency risk.

## Exploring Different Hedge Ratio Types

The minimum variance hedge ratio is important when [cross-hedging](https://www.investopedia.com/terms/c/crosshedge.asp), which aims to minimize the variance of the position’s value. The minimum variance hedge ratio, or optimal hedge ratio, is an important factor in determining the optimal number of futures contracts to purchase to hedge a position.

To calculate it, multiply the [correlation coefficient](https://www.investopedia.com/terms/c/correlationcoefficient.asp) of the spot and futures prices with the ratio of the spot price's [standard deviation](https://www.investopedia.com/terms/s/standarddeviation.asp) to the futures price's standard deviation. Once you have the optimal hedge ratio, calculate the needed futures contracts by dividing the product of the hedge ratio and total units by the size of one contract.

## Practical Example of Hedge Ratio Application

Assume that an airline company fears that the price of jet fuel will rise after the crude oil market has been trading at depressed levels. The airline company expects to purchase 15 million gallons of jet fuel over the next year, and wishes to hedge its purchase price. Let's assume a high correlation of 0.95 between oil futures and the jet fuel spot price.

Also, assume the standard deviations are 6% for oil futures and 3% for the jet fuel spot price. Therefore, the minimum variance hedge ratio is 0.475, or (0.95 \* (3% / 6%)). The New York Mercantile Exchange (NYMEX) [West Texas Intermediate (WTI)](https://www.investopedia.com/terms/w/wti.asp) crude oil futures contract has a contract size of 1,000 barrels or 42,000 gallons. Calculate 170 contracts, using (0.475 \* 15 million) / 42,000. Thus, the airline buys 170 [NYMEX](https://www.investopedia.com/terms/n/nymex.asp) WTI oil contracts.

## How Do I Calculate the Hedge Ratio?

Divide the hedged position by the total position, and the quotient is the hedge ratio.

## Why Is a Minimum Variance Hedge Ratio Important?

The minimum variance hedge ratio helps determine the optimal number of options contracts needed to hedge a position. The ratio is important in cross-hedging, which aims to minimize the variance of a position’s value.

## Is There Another Name for the Minimum Variance Hedge Ratio?

Yes. The minimum variance hedge ratio is also known as the optimal hedge ratio. Either way you name it, it is an important factor in determining the optimal number of futures contracts to purchase to hedge a position.

## Key Insights into Hedge Ratios

The hedge ratio measures how much of a position is protected through hedging compared to the entire position, providing insight into exposure management. By understanding hedge ratios, such as the minimum variance hedge ratio, investors can optimize the number of contracts needed to effectively manage risk, especially in scenarios like cross-hedging. Whether using options or futures contracts, calculating the optimal hedge ratio is crucial in minimizing value variance and securing a position against market movements.   

> **Article Sources**
>
> 1.  CME Group. “[Crude Oil Futures—Contact Specs](https://www.cmegroup.com/markets/energy/crude-oil/light-sweet-crude.contractSpecs.html).”