Over-Hedging

What is Over-Hedging?

Over-hedging occurs when the size of the hedge, a form of insurance, is greater than the size of the original position, i.e. you purchased more insurance than is necessary. It fully protects the position from any future loss of value, but comes with opportunity cost and potential risks. When over-hedged, as opposed to being fully hedged where the net position is zero, the net position will be negative.

Over-Hedging

To understand this better, let's look at an example to understand what hedging means and how it is usually carried out and how a position could be over hedged. 

Let's assume that a trader is long 10,000 units of an ETF that tracks the FTSE 100 index. The long exposure means that they gain if the FTSE rises in price and vice versa. They now expect prices to decline over the next 3 months and would like to cover their position against any losses that are expected. An obvious measure is to sell their stake in the ETF of 10,000 units to avoid any losses and then buy it back after 3 months.

However, there is one more way to nullify any gains and losses in the upcoming three month period without selling any shares, which is to enter into a corresponding short position on the security. In the current example, the trader would enter into a short position in 10,000 units of the same ETF, thereby nullifying any gain or losses on the overall position.

The problem of over hedging arises when the number of contracts available to hedge does not match the number of positions held. In this example, let's assume that the minimum number of contracts to short is 12,000. This does not match the 10,000 long position and leads to an additional short position of 2,000 (12,000 - 10,000) units. Hence, over hedging leads to negative exposure to the original position.

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What Causes Over-Hedging?  

Over-hedging can result from:

  • A poorly structured hedge that is affected by price movements (results in an accidental over-hedge).

  • A risk-management tool (similar to buying insurance) that is used by investment managers based on their view of future price movements and market conditions.

If a hedge is poorly structured, the price movements in the original position can cause the hedge that was put into place to be greater than the original position. An example of this is when a futures contract is used to hedge a position, and the hedge is set up as a static hedge, an unchanging hedge. Over time, the value of the original position can, potentially, move away from the value of the futures contract that was used as the hedge. This can result in the position being over-hedged. To properly hedge such a position, a dynamic hedge, which requires frequent rebalancing of the hedge, is often preferred over a static hedge.

Investment managers can use over-hedging as a risk-management tool when they want to lock in a price or believe that market conditions will worsen, and would like to cover their current position now without the need to rebalance, or change the hedge, later. It is sometimes more cost-efficient to implement a hedge before market conditions worsen.

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Why is Over-Hedging Bad?

Being over-hedged is generally considered to be bad because although it fully protects from adverse price movements, it places a cap on any future favorable price movements, which limits future profit potential, also known as opportunity cost: giving up one benefit in pursuit of a different benefit. In this case the opportunity cost is: giving up upside potential in exchange for downside protection.

An over-hedged position may also create an unwanted speculative position, a bet, on the excess amount that is over-hedged. For an example of a speculative position, see the "Example" section below.

Over vs Under Hedging

If over-hedging is when the size of the hedge is greater than the original position, under-hedging is the opposite of this, i.e. under-hedging is when the size of the hedge is less than the original position. This happens when you purchase less insurance than is necessary to be fully insured (protected). The main differences are listed below:

  • Under-hedging leads to a positive exposure over the original position. Let's assume there is a long position of 10,000 units of an ETF and the maximum number of units available to short is 9,000 units. This does not match the 10,000 units desired to structure a fully hedged position, and leads to a positive position of 1,000 units (10,000 - 9,000). 

  • Being under hedged allows the position to benefit more from any potential upside, but is exposed to more downside risk, when compared to being over hedged.

Some reasons why an under hedged position may be created are: not enough units are available to create a fully hedged position, being fully hedged can be costly, or only some downside protection is desired in order to maintain some upside potential.

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Effect of Various Instruments On Over Hedged Positions

There are various financial instruments, or more commonly known as derivatives, available to accomplish a hedge; the asset type will dictate which derivative to use. The main three derivatives instruments are: forwards, futures, and options.

Forwards and Futures

A forward contract, or a forward, is a customizable over-the-counter (OTC) derivative contract between two parties who agree to exchange an asset (usually a commodity such as energy or livestock) at an agreed upon price on the contract settlement (expiration) date. At expiration, forward contracts can be settled in cash or by physical delivery of the asset. Since the terms of a forward contract, i.e. value, quantity, and settlement date, are fully customizable and must be agreed upon by both parties, it is easier to structure a fully hedge position in the forwards market.

A futures contract, or futures, is a standardized contract that is traded on a central exchange. Unlike forwards, futures are not customizable. Futures carry less counterparty risk than forwards since a futures contract is guaranteed by an exchange; however the standardized nature of the contract can lead to an over or under-hedged position because there may be a maximum or minimum number of units available to create a hedged position. For an example of a speculative position, see "Example of Over-Hedging" below. 

Options

Unlike forwards or futures, which are only available to larger institutions, options can be utilized by everyone, from large institutions to retail investors. For stocks in particular, one option contract is equal to 100 shares of a stock. This means that if a trader would like to hedge a stock position, the trader would need to have a position that is divisible by 100 in order to create a fully hedged position using options. If the position isn't divisible by 100, an over or under-hedged position will be created, meaning more shares will either need to be purchased or sold in the open market if the option is exercised.

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Examples Of Over-Hedging

Below we look at a few examples where this hedging scenario may occur either intentionally or unintentionally.

Over-Hedging A Foreign Asset Using Futures

Suppose a US investor has a foreign asset in Canada with a value of 90,000 CAD (Canadian dollar), and decides to hedge this position by entering into one futures contract to sell 100,000 CAD. This position is now over-hedged by 10,000 CAD. At expiration, if the Canadian dollar appreciates relative to the US dollar, the US investor must deliver more than the amount that is hedged to close the position; however, if the Canadian dollar depreciates relative to the US dollar, the investor will benefit from the over-hedged position since any loss in value is protected by the hedged position.  

Over-Hedging Using Options

Let's use the ETF example to help paint a better picture on how options can be used to hedge, or over-hedge, an existing position. If a trader has 90 shares of an ETF that tracks the FTSE 100 index and would like to purchase a put option to provide downside protection, this would create an over-hedged position since one contract is for 100 shares. This would mean that if the put option is exercised, the trader would need to purchase 10 additional shares of the ETF to deliver, or put, to the other party.

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Over-Hedging Based on Market Conditions 

Examples of when an investment manager may decide to intentionally over-hedge their position if:

  • They manage both a portfolio of bond liabilities and a bond asset portfolio designed to match, and pay off, the bond liabilities over time. 
  • There is a portfolio surplus (assets are greater than liabilities).
  • They expect market interest rates to increase in the future, i.e. when interest rates increase bond prices decrease.

By being over-hedged, the investment manager can take advantage of falling bond prices and retire some of the bond liabilities earlier than expected while protecting the original surplus and position.

When to Hedge?

Over-hedging, like all insurance, has its costs and benefits. Oftentimes, there aren't always perfect hedges available to the manager.

When faced with a situation where there is either an option to over-hedge or not hedge at all, the manager must use discretion and analyze current and future market conditions prior to making their decision.

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If the manager believes that there is a greater chance of adverse price movements over a given time horizon, they may find it more appropriate to over-hedge and limit potential upside for full downside protection. If adverse market conditions are believed to be transitory by the manager, then the manager may want to forgo downside protection and let the position play out on its own, thus providing unlimited upside potential, but also zero downside protection.

Sometimes, as seen in the example using futures above, it is actually strategic for a manager to over-hedge if they can take advantage of the expected market conditions. When managing a portfolio of liabilities that need to be retired, it could be costly to be unhedged or even fully hedged.

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