The hedge ratio is a measure of the proportion of an investment which is protected by a related hedging action. Hedging involves making a second investment which will pay off if the first investment loses money. It is designed to limit the potential losses of the original investment. Calculating the hedge ratio makes it easier to work out an investment firm's potential losses in a worst case scenario.
Arguably the most common use of hedging aims to deal with situations where an investor predicts a company's stock will do well in relation to rivals in the same industry. To achieve this, the investor needs to find a way of profiting when the company does better than its rivals, but minimizing losses when the entire industry performs badly. The solution is to hedge by buying stock in one company, but shorting stock in rival companies. Shorting means to borrow stock, sell it now, then buy it back and return it to the lender at a later date. This means that the investor will profit if the stock price falls, rather than if it rises.
The theory behind this form of hedging is that if the first company does well on its own merits, the investor will make a profit, but it is unlikely to make much difference to the stock of the second company. If the entire industry does badly, the investor will have made some money by shorting the second company, which minimizes the losses on the first company's stock. If the entire industry does well, the investor will lose money on the company it shorted, but hopefully will more than make this back through the profits it makes with its main investment in the first company.
The hedge ratio is a comparison of the investment for hedging purposes against the main investment. The higher the hedge ratio, the less risk the investor faces. Of course, a higher hedge ratio also means lower potential profits if the investment performs as hoped.
There are a wide variety of situations in which hedging can be used. It can apply to any pair of investments whose performance is in some way related, including factors such as currency exchange rates or commodity prices. The exact method of calculating the hedge ratio may vary from situation to situation, but the principle is always to compare the potential losses with hedging in place against the potential losses which were the main investment made without hedging.