Classic Hedge Strategy

The implicit assumption of the classic hedge ratio equal to one is that the prices of the spot commodity (in this case, the stock portfolio) and the futures contract will remain perfectly correlated over the entire hedge period. Then if the stock market does turn down as expected, as losses in the portfolio due to price declines in its composite stocks will be exactly offset by the gain on the futures position. Conversely, if stock prices rise, the portfolio’s gain will be offset by equal losses on the future position. Such a strategy implies that the objective of the classic hedge is risk minimization or elimination.