Final answer:
The hedge ratio is used to determine the number of options required to achieve 100% protection, meaning a complete offset of the risk in the underlying asset's position through a perfect hedge.
Step-by-step explanation:
The hedge ratio theoretically informs us how many options are needed to provide 100% protection against price movements in the underlying asset. The hedge ratio is a crucial concept in the field of finance, particularly in risk management and derivatives trading. It calculates the number of options or futures contracts needed to fully offset the risk in the position of the underlying security.
A hedge ratio of 1, or 100%, means that for every unit of the underlying asset exposed to price risk, there is an equivalent amount of protection through options. This level of protection ensures that any gains or losses in the value of the underlying asset are offset by corresponding losses or gains in the value of the options. When applied correctly, the hedge ratio can be used to achieve a perfect hedge, thereby completely eliminating the price risk of the underlying asset.