Over-Hedging

What Is Over-Hedging?

Over-hedging is a risk management strategy that utilizes an offsetting position which surpasses the size of the original position being hedged. The outcome might be a net position the other way of the initial position.

Over-hedging might be unintentional or deliberate.

Figuring out Over-Hedging

When over-hedged, the hedge put on is for a greater amount than the underlying position initially held by the one going into the hedge. The over-hedged position basically secures in a price for additional goods, commodities, or securities than is required to safeguard the position. At the point when one is over-hedged, it influences the ability to profit from the original position.

Illustration of Over-Hedging

Over-hedging in the futures market can involve inappropriately matching contract size to require. For instance, suppose a natural gas firm went into a January futures contract to sell 25,000 mm British warm units (mmbtu) at $3.50/mmbtu. In any case, the firm just has an inventory of 15,000 mmbtu that they're attempting to hedge. Due to the size of the futures contract, the firm currently has excess futures contracts that amount to 10,000 mmbtu.

That 10,000 mmbtu in over-hedging really opens up the firm to risk, as it turns into a speculative investment in the event that they don't have the underlying deliverable close by when the contract comes due. They would need to go out and get it on the open market for a profit or a loss relying upon what the price of natural gas does over that time span.

Any drop in the price of natural gas would be covered by the hedge, protecting the company's inventory price, and the company would get an extra profit by conveying the excess amount at a higher contract price than what it can purchase on the market. An increase in the price of natural gas, in any case, would see the company make not as much as market value on its inventory and afterward need to spend even more to satisfy the excess by buying it at the higher price.

Over-hedging is frequently finished unintentionally; however for some companies, a lack of any hedge is a far greater risk.

Over-Hedging versus No Hedging

As displayed above, over-hedging can really make extra risk instead of eliminate it. Over-hedging is basically exactly the same thing as under-hedging in that both are ill-advised utilizations of the hedge strategy.

There are, of course, circumstances where an inadequately set-up hedge is better than no hedge by any means. In the natural gas scenario over, the company secures in its price for its whole inventory and afterward conjectures on market prices accidentally. In a down market, the over-hedging helps the company, yet the important point is that a lack of a hedge would mean a deep loss on the firm's whole inventory.

Features

• Over-hedging happens while an offsetting position is laid out that surpasses the original position.
• Like under-hedging, over-hedging is generally an inefficient utilization of a hedging strategy.
• Regardless of whether expected, over-hedging brings about a net contradicting position to the original one.