Hedge ratio: what share of your exposure should you really hedge?
Hedging 100 % protects against one risk and creates another. A four-input method for setting a ratio you can defend to your managing director, plus a ready-made grid of ratios by horizon.
« We hedge everything, then we can stop worrying. » It is the most common answer, and rarely the right one. Hedging an entire forecast exposure does not remove the risk: it moves it from the currency to the forecast.
Why 100 % is not the default answer
A forward contract is a firm commitment. If you hedge 100 % of a dollar sales budget and those sales come in at 70 %, you hold a forward position on 30 % of a flow that does not exist. At maturity you have to deliver dollars you never received: you buy them at spot, at the rate of the day, and discover your hedge has become a bet.
Over-hedging is a speculative position that does not say its name. A statutory auditor treats it as one, and it falls outside the scope of hedge accounting.
The four inputs that set the ratio
- 1How certain the flow is
Contracted and signed: the flow is near certain, a high ratio is justified. Budgeted with no order: the historical reliability of your budgets becomes the ceiling for a reasonable ratio.
- 2The horizon
Your ability to forecast decays with time. The ratio should decay with it. A constant ratio over 12 months reflects a forecast you do not have.
- 3How thick the margin is
A 4 % net margin is destroyed by a 5 % currency move. A 30 % margin absorbs it. The thinner the margin, the higher the ratio and the longer the horizon should be.
- 4Your ability to pass it on
If your commercial contract contains a price-revision clause indexed to the exchange rate, part of the risk is already transferred to the customer. The financial ratio can be reduced accordingly.
A starting grid, to be adjusted
| Horizon | Contracted flow | Reliably budgeted flow | Conditional flow |
|---|---|---|---|
| 0 – 3 months | 90 – 100% | 70 – 80% | Option only |
| 3 – 6 months | 80 – 90% | 50 – 70% | Option only |
| 6 – 12 months | 60 – 80% | 30 – 50% | Not hedged |
| 12 – 24 months | 40 – 60% | 0 – 30% | Not hedged |
The case of conditional flows
A tender not yet awarded, a commercial option, a contract subject to conditions: these flows do not support a forward contract. They call for a call or a put, whose maximum loss is bounded by the premium. If the business is lost, you lose the premium — not the whole currency move on a full notional.
How to word it in a policy
The ratio should not be a single figure but a band. Example wording: « Contracted flows inside six months are hedged between 80 % and 95 %. The finance director adjusts freely within that band. Any departure from the band is reported to the audit committee at the following closing. »
That wording gives operational flexibility while setting an auditable limit. It is that pairing — bounded latitude — that a statutory auditor is looking for.
Measure what a ratio does to your margin
The exposure simulator projects the effect of FX on your commercial margin over 12 months, calibrated on today's market volatility.
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Frequently asked questions
The questions finance departments ask most often on this topic
Can a hedge ratio exceed 100 %?
Technically yes, economically no. Beyond 100 % of the underlying flow, the excess is an open position. Some policies allow a small tolerance (up to 105 %) to absorb invoicing rounding, but it must be written down and capped.
How do you justify your ratio to a statutory auditor?
Through a written document predating the transactions, linking the ratio to the nature of the flow and its horizon, and through evidence of the underlying flows (order book, approved budget). It is the anteriority of the documentation that counts: a ratio justified in hindsight does not qualify for hedge accounting.
Do you need a different ratio per currency?
Yes, where currencies do not behave the same way or do not cost the same to hedge. Dollar exposure and Turkish lira exposure do not call for the same answer: on currencies with a wide rate differential, the cost of carry makes long-dated hedging very expensive and pushes towards shorter ratios.