Why Is Over-Hedging Bad?

What Is Over-Hedging?

Over-hedging refers to a situation where an individual or organisation while attempting to mitigate risks through hedging strategies, ends up taking a position that exceeds the actual exposure they were trying to protect. This can happen when the quantity or size of the hedge is larger than necessary, leading to additional costs or complexities. Over-hedging can be a result of miscalculations, misjudgment of risk exposure, or overzealous risk aversion. While hedging is often employed to reduce risks, over-hedging can have its downsides, including increased expenses and potentially missing out on favourable market movements. Careful analysis and proper risk assessment are essential to avoid unintended consequences of over-hedging....

What Causes Over-Hedging?

1. Inaccurate Risk Assessment: Inaccurate risk assessment is a primary cause of over-hedging, occurring when individuals or organisations misjudge the extent of their actual exposure to financial risk. It often results from flawed or incomplete analysis of potential risks, leading to the implementation of hedges that are larger than necessary. Such misjudgments can stem from a lack of understanding of market dynamics, unreliable data, or an overly pessimistic outlook on risk....

Why Is Over-Hedging Bad?

1. Increased Costs: Over-hedging typically involves taking larger positions in hedging instruments like futures or options, incurring additional costs. These costs can eat into profits or increase losses, offsetting the benefits of risk mitigation....

Effect Of Various Instruments on Over Hedged Positions

1. Forward Contracts: If a company overhedges using forward contracts, it essentially locks in a future exchange rate or commodity price. This can provide certainty but might also limit the company’s ability to benefit from favourable price movements. However, forward contracts do not involve an upfront premium, which can be advantageous....

Examples of Over-Hedging

1. Airlines and Fuel Hedges: Airlines are known for hedging their fuel costs to mitigate the impact of volatile oil prices. However, in some cases, airlines have over-hedged their fuel consumption. For example, American Airlines over-hedged its fuel costs in 2016. Due to a drop in oil prices and increased fuel efficiency of its fleet, the airline had committed to buying more fuel than it needed. When oil prices remained low, American Airlines incurred significant losses on its hedging contracts....

When to Hedge?

Deciding when to hedge is a crucial aspect of risk management, and the timing of hedging depends on various factors, including the company’s risk tolerance, its exposure to market fluctuations, and its financial goals. Here are some key considerations for determining when to hedge:...

Difference Between Overhedging and Underhedging

Basis Overhedging Underhedging Objective To protect against unfavourable price or rate movements while potentially sacrificing some benefits from favourable movements. To minimise the cost of hedging and take advantage of favourable market movements while accepting more risk. Risk Exposure Reduced exposure to unfavourable market movements. Increased exposure to unfavourable market movements. Profit Potential Reduced profit potential due to sacrificing some favourable market movements. Increased profit potential if favourable market movements occur. Cost of Hedging Higher costs due to hedging more than needed, including premiums and margin requirements. Lower costs as fewer hedges are used, potentially reducing premiums and collateral requirements. Financial Impact This may lead to financial losses if market conditions remain favourable and the overhedging is costly. This may lead to financial losses if unfavourable market conditions persist and underhedging results in higher costs or losses. Risk Tolerance Generally lower risk tolerance as the primary goal is to limit exposure to unfavourable events. Generally higher risk tolerance as the company is willing to accept more exposure to market fluctuations. Strategy Flexibility Lower flexibility, as overhedging limits the company’s ability to benefit from favourable market movements. Higher flexibility, as underhedging allows the company to capture more gains from favourable market movements. Adjustments Needed May require adjustments or unwind strategies to reduce overhedging if market conditions change. May require adjustments to increase hedges or implement risk mitigation strategies if market conditions worsen....