Series 3: 2.2.2.1.1. Direct Hedge

2.2.2.1.1. Direct Hedge

A direct hedge is a hedge in which the underlying instrument of the futures contract is the same as the cash instrument being hedged. In the previous example, the cash instrument being hedged is a 90-day Eurodollar time deposit that terminates on the day the risk exposure begins. This is the same product as the underlying instrument of the Eurodollar futures contract. Determining the hedge ratio, the number of contracts to buy or sell, is simply a matter of dividing the amount of cash exposure ($10 million in the above example) by the market value of the futures contract. For simplicity, let’s say the market value of the futures contract is its $1 million face value. Then the hedge ratio is 10:1. Ten futures contracts will be needed to hedge the $10 million Eurodollars at risk.

This direct hedge happens to be a perfect hedge, because the transaction date and the futures settlement date are the s