Over-Hedging

Over-Hedging

The practice of taking an offsetting position on an investment to reduce its risk where the offsetting position is greater than the original position. For example, one may buy 100 shares of AT&T and then buy a put option, giving one the right, but not the obligation, to sell 125 shares of AT&T. While this completely eliminates the risk associated with the first 100 shares declining in price, over-hedging creates a new risk for the extra 25 shares in the put contract.
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"Just drafting the hedging policy was something that was important so that we were in line with our forecast and not over-hedging. Going through the entire process, from demand planning to the forecasting to the actual hedge--I've done that for currency as well as commodities and banking."
Thus, doing so requires the treasury team to decide whether to set contracts equal to the forecast, which would put the company at risk of over-hedging its actual exposure, or to set contracts less than the forecast, which obviously creates its own risk.
Exchange rates quoted today are: [pounds sterling]/$ Spot rate 0.5120 - 0.5152 One-month forward rate 0.5141 - 0.5171 Three-month forward rate 0.5171 - 0.5202 Interest rates (p.a.) are: % UK 5 - 5.5 US 2 - 2.4 Futures market ([pounds sterling]100,000 contracts, margins are $1,000 per contract [pounds sterling]1 June $1.9305 September $1.9170 December $1.9005 Note: The contract size of [pounds sterling]100,000 has been chosen to avoid under--or over-hedging. The usual contract size 1s162,500.
Over-hedging occurred in six months and under-hedging occurred during 12 months.
Where complete data isn't available, some companies may be conservative in their hedging strategies to avoid over-hedging. That can lead to unnecessary cost and risk.
Clearly, Ep>b since EU'[epsilon] < 0, even in the case of over-hedging (h>Y).
On the other hand, four futures contracts would represent an over-hedging of C$58,000.
Mr Wheeler went on: 'This does not mean that hedging should be avoided it is of course essential to avoid undue risk but that over-hedging would not be cost-effective in the medium or long term.
This type of over-hedging strategy reflects an extremely conservative approach to revenue planning.
Lastly, through a single limit structure, a company is able to eliminate over-hedging and the frictional costs associated with procuring separate financial instruments.