The relationship between the number of contracts required for a direct hedge and the number of contracts required to hedge in a specific situation. The concept of hedging is to match the size of a positive cash flow from a gaining futures position with the expected negative cash flow created by unfavorable cash market price movements. If the expected cash flow from a $1 million face-value T-Bill futures contract is one-half as large as the expected cash market loss on a $1 million face-value instrument being hedged (for whatever reason), then two futures contracts are needed to hedge each $1 million of face value. The hedge ratio is 2:1.
Hedge ratios are used frequently when hedging with futures options, interest rate futures, and stock index futures, to aid in matching expected cash flows. Generally, the hedge ratio between the number of futures options required and the number of futures contracts is 1: 1. For interest rate and stock index futures, the ratios may vary depending on the correlation between price movement of the assets being hedged and the futures contracts or options used to hedge them. Most agricultural hedge ratios are 1: 1.