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Over-Hedging

Updated on January 4, 2024
Article byPrakhar Gajendrakar
Edited byRaisa Ali
Reviewed byDheeraj Vaidya, CFA, FRM

Over-Hedging Definition

Over-hedging refers to a hedging strategy to offset losses by taking an offsetting position against the original position, and the offsetting position size is larger than the original position. In simple terms, placing an opposing bet so much identical to the original one minimizes the risk.

It is a risk management strategy common in the financial markets. For example, an investor can buy a fixed number of shares of a stock and at the same time buy a put option to sell more shares of the same stock; if the price of the shares bought falls, the put option act as a protective measure.

Key Takeaways

  • Over-hedging is a hedging strategy for risk management in which an offsetting position of greater size hedges the original position.
  • It is often considered an ineffective application of hedging strategy to create a net position in the opposite direction, which can also happen by mistake, creating additional risk.
  • If an investor bought n number of shares of a stock and then bought a put option enabling him to sell more than n number of the same shares, it portrays an example.
  • Example of its applications is over-hedging barrier options and currency over-hedging.

Over-Hedging Explained

Over-hedging act like insurance for investments by strategically setting positions to avert investment risksInvestment RisksInvestment risk is the probability or uncertainty of losses rather than expected profit from investment due to a fall in the fair price of securities such as bonds, stocks, real estate. In addition, each type of investment is prone to some degree of investment or default risk.read more. It can minimize the market risksMarket RisksMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk.read more and prevent investments from being affected by the negative impacts of a downtrend. Portfolio managers, corporations, and individual investors apply it to reduce the risk due to price decline. Its usage is very common in the oil or fuel industry. Other common applications are over-hedging interest rate swaps, currencies, and barrier options.

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In one way, it is explored as being over-protective about investments and affecting the original position’s profitProfitProfit refers to the earnings that an individual or business takes home after all the costs are paid. In economics, the term is associated with monetary gains. read more potential. Any investment hedged by an offsetting position will only work if a negative event like a price decline occurs. Even after placing an offset position, there are chances for the investment to incur a loss. It is inherent that every hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more strategy has a cost associated with it, and the advantages must justify the expenseExpenseAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.read more incurred.

Examples

Suppose, in a hypothetical situation, during a high school football game, Kevin places a bet of $500 on team A winning and then places another bet with another group of friends, placing a bet of $510 on team B winning. In this situation, the chances of Kevin losing the money are minimized but, at the same time, defeats the purpose of winning the bet or registering a profit.

Tweaking the first example, if Kevin has his original bet of $500 on team A winning and places a small bet of $200 on team B winning, it is called under-hedging. Here if team A wins, Kevin will earn $500 but will pay $200 for his second bet making a net profit of $300, and in case team B wins, Kevin will earn $200 but will have to pay $500 for his original position making a net loss of $300. Hence, it is a contrasting strategy to over-hedging.

Consider another example. Investor A decides to purchase 100 shares of ABC company stock to enter into a long positionLong PositionLong position denotes buying of a stock, currency or commodity in the hope that the future price will get higher from the present price. The security can be bought in the cash market or in the derivative market. The course of action suggests that the investor or the trader is expecting an upward movement of the stock from is prevailing levels.read more. However, fear of market volatilityVolatilityVolatility is the rate of fluctuations in the trading price of securities for a specific return. It is the shift of asset prices between a higher value and a lower value over a specific trading period. read more made him purchase a put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more to sell more than 100 shares of ABC. This provision saves the 100 shares from making a loss because if the price falls below the strike price, which is greater than or equal to the per-share value, it exercises the put option, and to complete the put option transaction, the investor A has to arrange for the additional shares in the put contract and there the risk happens.

How to Stop Over-Hedging?

How to Stop Over-Hedging

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Frequently Asked Questions (FAQs)

What does it mean to hedge against something?

Hedging is a protective measure or investment against possible losses. It is common in financial markets where investors hedge one investment or position by conducting another trade. This risk management strategy comes with a cost like a premium paid for buying it. Hedging strategies are commonly used in the securities and commodities market.

What is over-hedging?

It is a risk management method that uses a hedging technique. It occurs when a trader takes an offsetting position against the original position, but the magnitude of the offsetting position is bigger than the original position.

What is under-hedge?

Under-hedging means establishing an offsetting position but not balancing the original position. In this type of strategy, there are more chances of losing money because the offsetting position is not fully utilized to cancel out the original position. The loss is lowered, but still, there is a loss.

This has been a Guide to What is Over-Hedging. We explain its definition, examples, and methods to stop it and apply it to interest rate swaps & currencies. You can learn more from the following articles –

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