What formula represents the hedge ratio in finance?

The hedge ratio is a crucial concept in finance, particularly in the context of risk management and derivatives trading. It measures the proportion of a position being hedged relative to the exposure being hedged, allowing for a strategic reduction of risk.

The correct formula for the hedge ratio is expressed as Beta(s,f) = Cov(s,f) / sigma(p). In this context, Beta represents the sensitivity of the asset's price relative to the price movements of a benchmark or market portfolio. Specifically, it reflects how much the price of an asset (the security) is expected to change when the price of the benchmark (the asset to which it is compared) changes.

The covariance (Cov(s,f)) quantifies the degree to which two variables move in relation to each other—in this case, the security and the factor it is being hedged against. Meanwhile, sigma(p), which represents the volatility of the price of the benchmark, serves as a normalization factor, allowing the hedge ratio to be calculated effectively.

Having the hedge ratio defined in terms of Beta makes it clear how the asset's risk aligns with the overall market risk represented by the benchmark. This can be particularly useful when constructing a hedging strategy, as it allows traders and risk managers to tailor their positions