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What is Hedging and hedge ratio?

Hedging is a technique to control or minimize the risk and losses in stock and commodity market. Hedgers can cover their positions in the derivative market against their exposure in cash market.

Hedge Ratio
- is the ratio of number of futures contracts to be purchased or sold, to the quantity  of cash asset that is required to be hedged. hedge ratio is the amount of movement in the call option per rupee movement of the underlying asset.

For e.g - A have stocks purchased worth Rs. 500000. To hedge this complete amount, A will need to see how the stocks are correlated with the nifty, if I want to hedge against market. Suppose, the lot size of nifty is of 100 and is trading at 5000. Assuming the correlation to be 1, A need to short 1 lot of nifty, so that it hedges my position. Hence, the hedge ratio is 1.

Alternative hedging methods

The traditional way of reducing price risk was to reduce price exposure. Derivatives are useful to hedge risk:
1) Over short periods of time
2) Of a specific magnitude
3) There is more control on managing risk
4) It required little capital.

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