Over-Hedging

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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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overhedging strategy might be exploited systematically in a way that
Relying on the traditional approach of managing individual risks separately in their own risk silos tends too often lead to serious and systematic errors in risk identification and assessment." As we show in our analysis, neglecting dependencies can result in significant deviations from optimal enterprise-wide strategic plans, potentially leading to catastrophic outcomes (in face of high positive dependence), and/or overhedging in situations when "natural hedging" opportunities are ignored.
Mortgage bankers are already increasingly aware of the potential dangers of overhedging. Says Hayden at Chase Manhattan, "You can't hedge out every iota." It may be more important to get the hedging "directionally and proportionally correct," he adds.
notes "that from a shareholder perspective, a 'net revenue hedge is much less costly and more efficient' than individual options, since it can be custom-designed and avoids 'overhedging.' The hitch for the client is that a custom-designed net revenue hedge will provide a lower payoff than individual option positions under certain market conditions."
This is because of the overhedging scenario when the cash flow sensitivity to precipitation is actually lower than expected, upon which the payoff is based.
The more risk-seeking managers will also find the hedging instrument valuable because it provides them with induced uncertainties due to overhedging. (33)
Propositions 3 and 4 show that, ex ante, the insurer can invest more aggressively in new opportunities that promise an above-market return at time 1, hedge less with products that appear very costly at time 1, and cut back on overpaying for and/or overhedging with products whose chief purpose is to improve distributional asymmetries.