Over-HedgingExplained & Defined
Over-hedging refers to a hedging strategy that is used to reduce risks and offset potential losses from an initial investment position.
Over-hedging occurs when an offsetting position exceeds the size used to ensure against losses is larger in size than the initial position for which it is being used as a hedge.
Though over-hedging can protect against any potential loss in value from the initial position, it presents its own potential for loss as well as an opportunity cost.
This is in contrast to under-hedging, where the offsetting position is less than the original position.
What Is Over-Hedging?
Over-hedging refers to a type of risk management strategy in which an offsetting position is used which is greater in size than the original position. This could result in a
net position that is negative.
Over-hedging can be used as a risk management strategy, or it could be unintentional.
Causes of Over-Hedging
Over-doing can be caused by a hedge that was not structured well, thus causing it the be affected by movements in the price of the original position.
When a hedge is not structured well, a change in the price of the original position could cause the hedge placed to exceed the original position.
Or, it may be used like a form of insurance by investment managers when they want to ensure a certain price.
They may also over-hedge because they think that market conditions will be getting worse, and they want to cover their existing position without having to change their hedge or rebalance at a later time.
Putting a hedge in place before the market worsens could save money.
Over-Hedging Explained
Over-Hedging occurs when a hedge is put in place for an amount that exceeds the underlying position originally held by the person who placed the hedge.
An over-hedged position basically guarantees a certain price for additional securities, goods, or services than is necessary to avoid potential risks.
Therefore, if an investor is over-hedged, it affects their ability to earn a profit from their initial position.
Over-Hedging Example
As an example, suppose an investor buys 200 shares of stock in Company XYZ in order to take a long position.
But, the investor is concerned about possible market volatility and purchased a put option to sell over 200 shares of XYZ.
Buying the put option means the 200 shares of Company XYZ stock will not result in a loss for the investor because should the price drop below the strike price, which is equal to or higher than the per-share value, the put option will be exercised.
However, the investor will be required to arrange for the additional shares that are included in the put contract, and this is where risk occurs.
Over-Hedging Versus No Hedging
The above example shows how in some cases, over-hedging can create more risk rather than eliminating risk.
As with under-hedging, over-hedging is not an appropriate use of a hedging strategy.
There are ways to stop over-hedging, such as:
- Concentrate on long-term investment strategies instead of looking for short-term gains. Trying to achieve short-term gains is very risky because of market volatility.
- Build a portfolio that consists of a variety of stocks and other investments. Make sure you research your potential investments to ensure your portfolio is diverse and will generate sufficient returns so as to avoid the need to use hedging as a way of precluding risk.
FAQs
What Is Hedging?
Hedging is a strategy in which an investor attempts to limit their financial risk by buying and holding an investment to try and reduce the risk of a loss for an existing position.
What Is the Difference Between Over-Hedging and Under-Hedging?
Over-hedging is a risk management strategy in which a hedging technique is used. An investor uses over-hedging by taking an offsetting position that exceeds the size of the initial position. In contrast, under-hedging involves taking an offsetting position that does not balance the initial position.
Under-hedging does increase the risk of losing money since the offsetting position does not balance the initial position.
Key Takeaways
- Over-hedging happens when an offsetting position is put in place that is greater than the original position.
- Over-hedging is often thought to be an ineffective use of hedging strategy by creating a net position that is in the opposite direction. This can occur by accident, thus causing additional risk.
- Under-hedging and over-hedging are both thought to be inefficient uses of hedging strategies.
- Currency over-hedging and over-hedging barrier options are both applications of over-hedging.
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Weatherhead School of Management "Hedging with Futures Contracts" Chapter 3. August 23, 2022