Executive summary

A hedge is a deliberate decision about which risks to keep and which to remove. Good hedge design isolates the risks you are actually paid to take — basis, service, structuring — and neutralises the rest: flat price, freight, currency and interest-rate exposure. The art is choosing the right instrument and the right size.

In plain English

Start by listing every risk in the trade: flat price, basis, freight, FX, interest rate. For each, decide whether to keep it or hedge it, and with what — futures for flat price, FFAs for freight, FX forwards for currency, and so on. The hedge ratio is how many units of the instrument you use per unit of physical.

Hedge ratio

Instrument units per unit of physical exposure. 1:1 when they match exactly; adjusted for contract size and correlation.

Cross hedge

Hedging with a related but non-identical instrument (e.g. jet fuel hedged with gasoil) — introduces extra basis risk.

Over-/under-hedging

Hedging more or fewer units than you actually hold — which turns a hedge into a directional bet.

Why traders care

Hedge design determines your residual risk. Under-hedge and you are still exposed to the move you tried to remove. Over-hedge and you have created a brand-new speculative position in the opposite direction. Use the wrong instrument (a loose cross hedge) and you swap a known risk for an uncontrolled basis risk. The ratio and instrument choices are where a hedge succeeds or quietly fails.

Operator connection

The physical numbers the operator confirms feed the hedge directly. Final loaded quantity, the actual delivery month, the currency of settlement — a 5% change in loaded tonnage is a 5% mismatch in the hedge ratio. Hedges are designed on expected volumes and must be trued up to what the operator actually executes.

Further reading

• John C. Hull, Options, Futures, and Other Derivatives — hedging with futures and the minimum-variance hedge ratio.
• CME Group — self-study hedging guides (grains, energy, FX).