How is the hedging ratio defined?

The hedging ratio is defined as the percentage of the duration gap closed with derivatives. This concept is primarily used in asset-liability management and risk management strategies, particularly in fixed income portfolios.

When a firm or an investor uses derivatives, such as interest rate swaps or options, to manage interest rate risk, the hedging ratio quantifies how much of the exposure to interest rate changes is mitigated through these instruments. By assessing the duration gap—a measure of interest rate sensitivity—the hedging ratio helps determine the extent to which derivatives can offset potential losses arising from changes in interest rates.

For example, if an investor has a portfolio with a duration of 5 years and engages in a swap that effectively reduces their portfolio's duration to 3 years, they have closed a portion of their duration gap. The hedging ratio would allow the investor to understand how much of their risk has been managed through this strategy.

In contrast, the other definitions provided in the options refer to different financial concepts: the percentage of portfolio growth needed relates to growth objectives; the ratio of assets to liabilities is a measure of solvency or liquidity; and the percentage of market risk exposure pertains to a broader view of total risk rather than the specific mitigation of duration risk through